Trader Note

Post-Christmas Monday: Slow trade in Asia to EU when move starts and continues lower (Rally Reversion).

Gold and Risk in 2016

Use physical gold to secure wealth. Use futures options to hedge your account.


The precious metals market has been heated lately. There are plenty of reasons to fear the coming collapse, as any gold bug site will tell you. The most salient issues would be:


Failure at the Comex

There are still huge amounts of outstanding long contracts vs. deliverable ounces in the vaults. This means that a failure to deliver will force a “cash settlement” situation. This will cause physical prices to soar the day after the settlement is made. This could be as high as 5 times current values, and potentially much higher longer term.


Trade War

China has been moving huge quantities of steel. This has lead nations around the world to accuse them of “dumping.” The USA instituted tariffs. UK and Australia have steel plants closing, creating yells for protectionist polices. Australia has a free trade agreement with China, so changing the nature of that might be highly detrimental for Australian markets. China is in control of 98% of rare earths, which means they have the ultimate trade war weapon against any technology production, of which the world is dependent. So China is in a better position to ramp up a trade war than the most vocal critics.

As the Chinese housing market suffers, so the investors fleeing Chinese money control will seek to cash out of overheated markets. This fares poorly for countries like Australia that generate huge tax revenues from property markets. The UK is already feeling the bite as Russian Oligarch money seeks other markets. Include the exodus of Chinese buyers, and real estate may find a hard landing.



The world is dependent on oil. Low oil has flow on effects, like lower production of ethanol leading to less demand for sugar moving sugar prices lower. Low oil prices also means that commodities suppliers (corn, wheat, hogs, miners, etc.) can still profit at lower prices. However, when price moves higher, non-hedged industries dependent on oil will suffer (shipping, airlines, mining, etc.) or be forced to pass costs into market creating higher end prices. Low oil prices will not last indefinitely.

The current price means that miners can continue production at lower input costs. This will not hold longer term so as input costs rise, expect the increased price in the end product (gold, silver, coal, rare earths, etc.). Hedged producers will be better able to capitalize, but industries as a whole will be hesitant to sell into a market that doesn’t yield profits. This may lead to bankruptcies and closures, longer term, which will effectively drive the underlying materials price higher.


Banking Collapse

Most people don’t realize that their accounts are forfeit in the event of a banking collapse. Currently, most bank accounts are considered “creditors” of the banks. That means that long term savers’ money will likely be used to bail out banks with massive derivatives books when they fail (Not IF they fail, but WHEN they fail). The FDIC does not have sufficient funds to cover these losses (100 trillion estimate), nor does the USA government. The Too-Big-To-Fail have only gotten larger as they use “mark to model” to justify higher risks on illiquid assets. When these assets are actually sold into the market, the REAL price is nowhere near estimated value price. This asset re-pricing will have an avalanching effect as many of the holders of these assets seek to exit a market where buyers are nonexistent. This will lead to a collapse of these derivative asset classes. In the end, account holders assets will be wiped away.

In the EU bank failures, pennies on the dollar were paid. Account holders were given shares in banks that they were unable to sell. When these shares are allowed to be traded, it is a guarantee that the share price will collapse due to selling pressure.

Deutsche Bank has been struggling as investors digest the reality that the DB derivatives book is nearly 100 times greater than German GDP. If there is a collapse of DB, Germany will try to save this bank… But at what cost? Savers will lose. Taxes will surge higher. German markets will lock up as the biggest local trading house is slowly audited to find bread crumbs to pay off shareholders.

By comparison, DB is a small fish in the derivatives market compared to USA banks. So there is a high potential for failure across the entire financial sector.

If you haven’t seen this image description of derivatives markets, you should (it is probably much worse now than it was when this image was created):

Australia keeps a watch on the OTC derivatives markets:

In Australia, the only legislation created to regulate the exposure was to create a slush fund (from savings accounts) to bail out banks in the event of a failure. The slush fund is so small that it couldn’t bail out a single community branch, much less the entire banking sector. So the effectiveness of this will be moot.

In the end, government interventions in these markets will likely exacerbate the problem. It will likely lock up funds people require to survive. Collapsing markets will destroy savers accounts and wipe away longer term personal wealth. Governments have never been effective in saving people, only industry.




Gold Bullion

The short statement is: Buy some bullion.

Current bullion price is cheap for the level of security it provides. A couple of ounces of gold, in hand, will ensure that when your accounts are locked up that you can still feed yourself. The risk-reward profile of bullion ownership is based in the ability to continue to function at normal levels when the world around you is in chaos. That level of security is currently at a fair price. It will be too late to hedge such risk when it becomes a necessity.


Gold Futures

Short: Look for late year contracts for potential profits on long positions (DEC16).

As a trader, capitalizing on market discrepancies is the goal. Currently, markets are in flux. There is sufficient selling action to indicate that money is looking for a move lower this year. This could be a big move or merely a good size correction. In such a move, cash on the sidelines will allow traders to find bargains (“the best time to buy is when there is blood on the streets”). When markets drop, EVERYTHING is sold off. So hedging such risk with the same assets that are collapsing will not work.

Currently, gold is bid. There is buying strength in gold. In the futures market, this is highly volatile as traders use futures contracts only as short term hedges. These contracts are not “value buys” but are merely surrogate liquid trades to underlying commodities. As such, the buying and selling of these contracts does not necessarily reflect the underlying value.

As a trader, capitalizing on moves is how profits are made. So, expecting a market pull-back this year is being deemed a highly probable event. This pullback will have money fleeing into hedges (gold, silver, bonds, oil, etc.) to attempt to capitalize on fear and collapse. This means that money flows into contracts like gold futures will boost prices.

To capitalize on these moves, gold futures options contracts have value. The capital outlay for such contracts will be the maximum you can lose (so gauge your own risk accordingly). Such contracts are NOT a long term investment, but a position to capitalize on high risk markets. Currently, out of the money calls on gold are inexpensive. These derivatives to gold are very different to the outstanding bank derivatives markets in that these instruments are valued at market in a semi-liquid environment. In the event of a market failure, these derivatives paid out in cash would be how you would exit this market anyway (probably at a lower price than that which is fair, but still greater price than your initial entry). So this makes holding these instruments a potential for wealth generation and a decent hedge of risk.

This is NOT a bet-the-farm trade. This will NOT substitute for holding cash or hedging systemic risk of markets. This will not protect from bank and currency failures. A position in gold futures and gold futures options is a chance to make some money on a failing market. This does not assume that the money made will maintain the buying power of the initial investment. However, it will likely outperform markets that are collapsing. So it may be a viable place to hedge assets.

Options have a “time” component to them, so sitting on them longer term will evaporate value if underlying doesn’t move. If those options are out-of-the-money, and price does not move in your favor, then all of your input capital will evaporate (you will lose it all). So risk what you can afford for these gains. Purchasing out-of-the-money calls at a very high strike price is akin to buying a lottery ticket, but the risk of loss is also lottery-ticket high. As such, choose strike prices that are likely and reasonable.

Personally, I like near out-of-the-money call options for December 2016 at strike prices: 1350, 1400, 1450, and 1500. Round numbers have more volume, so they are often more liquid. Waiting for a dip in underlying price will yield a better entry price. Similarly, surging underlying price will create a higher priced exit. December and June contracts traditionally have the highest volumes.

Be aware that the gold price will often dip into summer. It traditionally finds a bottom between April and October. This means that there is the potential for a move lower during the summer doldrums. This would be an opportunity to enter or add to an existing position.
Market sentiment is currently quite negative. The market is anticipating another shock as a point to sell off, fast. This may make an early year entry into gold futures a safer option.

Using a “scale in” approach will serve traders well. Enter at the current value on small amounts. If price moves lower, add to that position with lower strike prices or more of the existing strike prices. Look for moves higher in the underlying as a place to take some profits off the table and re-enter at better prices. Don’t exit completely from a position to hedge against collapse, but look for stable market points as a chance to take profits.


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