For Gold, The High Is In - For Now

07/02/10 09:48:35 AM

by Donald W. Pendergast, Jr.

Is the gold bull market dead? No one knows, but the probabilities favor at least a corrective move down toward $1,150 -- at a minimum.

Security: Gold, GC, GLD
Position: Sell

What a run for gold over the past 10 years or so. As recently as the end of June, the yellow metal had tacked on gains of 400% since bottoming out at about $255 back in April 2001. However, all bull markets eventually come to an end. Is this the end for gold, or is this just another in a series of proportional pullbacks?

FIGURE 1: GC, MONTHLY. THere are four reasons to sell an OTM gold call, but there are two others of equal importance: 1. Hedge funds and large specs are still overwhelmingly long. 2. Seasonality charts suggest more weakness ahead until the autumn.

Graphic provided by: MetaStock.

Graphic provided by: WB Detrend RT EOD from ProfitTrader for MetaStock.

Nothing fancy on the monthly chart (Figure 1), although the pronounced bearish divergence between the detrend oscillator and price action is cause of concern for gold bulls. At the same time, hedge funds and other large speculators in the gold futures market are still holding incredibly large positions in gold futures contracts, leaving little room to induce new longs to bid the price of the metal higher. Added to this bearish mix is the fact that an inordinate (massive?) number of TV, Internet, and newspaper ads are pleading with consumers to buy gold.

I had to laugh at this, seeing an ex-Watergate scandal "celebrity" say in one of these ads that he had already made large gains in gold over the years. I suppose he now needs you to do your patriotic duty and take his beloved gold off his hands. He made his profits, sees the top looming, and now needs you to show up with your wheelbarrow in one hand and the US flag in the other, perhaps?

Oh, yes, there's more. The recent break above the Fibonacci 162% extension level was very anemic, lacking any real follow-through. Finally, normal cyclical price action suggests that at the very least, the metal has just completed a midcycle high, one that should bring prices back toward the uptrend line near $1,160.

Is there any doubt that I am somewhat bearish on gold right now? Here's a simple, modest-risk call option sale that those who are neutral to bearish on gold may find to be right up their alley.

As of the close on July 1, 2010, you could sell a December 2010 gold $1,750 call option for about $4.30 ($430). This call is more than $500 out-of-the-money (OTM) and only has four and a half months left until it expires. With all of the bearish evidence already described, would you believe there is actually another powerful bearish seasonal factor at work here? You probably already know it, but precious metals prices usually go soft during the summer months before regaining strength in the autumn. With all of these powerful factors at work, selling a far OTM gold call looks like a very reasonable course of action.

Here's how I might play this one:

Sell the call this week, preferably on a minor intraday spike higher, but as long as you get $400, you should be okay. Once in, watch what gold does should it penetrate the uptrend line near $1,160; a clean break on wide daily/weekly range on heavy volume is the likely tipoff that the lower support level between $1,010 and $1,050 could be the next stopping point. If that should happen, you'll really be in the catbird seat, as the option will have absolutely minuscule deltas that will give you real staying power with this option, or even the luxury of closing it out early for a substantial gain.

For risk control, buy the option back if you see gold suddenly reverse and the recent high at $1,265 is exceeded on heavy volume. It should also be said that gold is a very emotionally charged market, one capable of making very sharp directional changes with minimal notice. So if you get that breakdown toward $1,050, you might just decide to buy the call back early, make some nice money, and walk away satisfied. That would certainly be preferable to getting that ride down to $1,050 and then continuing to hold if gold reverses and suddenly shoots up to $1,400, leaving you with an open loss instead.

Check with your broker and see if you are qualified to sell futures options, and if you are, do a little extra research on your own to make sure you understand all of the potential risks and rewards that are part and parcel of trading a portfolio of futures options. I've sold calls and/or strangles in crude oil, gold, and silver and never had one loser, mostly because of the lack of the need for perfect market timing when selling OTM calls and puts in these commodities. It's actually a very stress-free way to trade, one that you may also wish to participate in.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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For Gold, The High Is In - For Now

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