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In This Issue:
In the aftermath of Tuesday's stock market selloff, is this a buying opportunity for gold? Or should you wait this one out?

March 1, 2007
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Gold -- What's Next?

Analysts and pundits will likely be debating the cause of Tuesday’s stock market selloff for the next several months. The story they are likely to overlook will be what happened to Gold. As someone who has been bullish gold for some time now (as a review of the TraderSavvy archive will attest), the $22+ selloff after the close of the COMEX was of concern to me. Is this a buying opportunity? Should we sit on the sidelines? What’s next for gold?

The first two things to consider are China and market psychology. One of the catalysts of the stock market break was concerns over the growth of China’s economy. China’s explosive growth over the last few years has been a driving force in commodities in general. Any reduction in this demand spills over into gold. Also, the typical market psychology of any market panic was seen in the US markets on Tuesday – heave everything overboard; the “throw the baby out with the bathwater" cliché.

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Once gold is able to work past these two things, the fundamentals remain as bullish as before, if not more so. To begin with, if the stock market confidence is shaken, or if we go into a longer-term sideways or correcting market, there is generally a flight to quality. This typically is to debt instruments such as notes and bonds, and to precious metals. A slowdown in China will affect the industrial metals, but gold should escape unscathed.

If the US dollar continues its downtrend, gold will likely benefit. The majority of gold transactions are done in dollars so a cheaper dollar makes gold attractive to investors converting from another currency. Additionally, US dollar investors look to gold in the same currency move as a “safe haven.”

Continued unrest in the Middle East is bullish for gold. Uncertainty with Iran makes markets skittish. Gold is a “safe haven” in times of global crisis.

The current break in the market, to me, is a buying opportunity – at least until the charts tell me different. If that is the case, what are the likely trading opportunities? How can a trader take advantage of this?

I think it is important to point out that one should note blindly get long the market right now. Make sure you have a plan. That plan should have a profit objective AND a “get out” point. Remember, failure to plan is planning to fail. I have seen a lot of traders get into a trade thinking the market would bounce. They jumped in without really planning the trade and when the market turned, they didn’t have a plan for that. Make sure you have the trade planned from all angles BEFORE you get in.

Here are some of the opportunities unfolding now:

20 EMA Setup

As of this writing (Wednesday), it looks as if we will settle below the 20 day exponential moving average. We would look to be a buyer of the April futures above this day’s high. Note the risk on this trade must be below 660. If that is too much risk for your account size or risk tolerance, do not take this trade. It is better to sit on the sidelines than be overleveraged.

Chart Copyright 2007 FutureSource

Bull Call Spreads

For a more conservative trade, this is a great opportunity to look for Bull Call Spreads. A bull call spread is an option position constructed by purchasing a close-to-the-money call and simultaneously selling a farther out-of-the-money call. The strike price that you sell will offset some of the cost of the strike that you buy, leaving the trader with a net debit (cost). But this cost will be less that buying the close-to-the-money call outright. The cost of entry is the most that the trader can lose on the trade. In exchange for getting closer to the actual market price, the trader gives up the unlimited upside of an outright call. So we want to choose the option that we sell with that in mind. If we believe the market will exceed that price, it would make more sense to just be long a call outright. The CBOT’s electronically traded 100oz. gold options are ideal for this trade because you can view the depth of book and bid/offer right on the screen.

The April 690/720 Bull Call Spread

We would purchase the April CBOT 100 oz. gold 690 call and sell the 720 call. The 690 strike is very close to the current market price. To buy this outright would cost us around $900. But by selling the 720 for about $300, we offset some of our entry cost.

So what is our risk and reward on this trade? The most we can lose is the cost of entry. This trade is reasonable at an entry cost of around $600. Our maximum gain will be achieved if gold is at or above 720 at expiration. This would be $3000 less the cost of entry. Our breakeven at expiration would be if gold were trading at or above 696.

By way of comparison, if we were to buy an outright call for the same entry cost, we would need to look at buying the 700 strike for $600. Gold would need to be at 706 at expiration for this trade to break even. To exceed the gain of the spread, it would need to be above 730, $10 higher than our spread. Gold would have to exceed a $40 move in the next month to outperform the spread.

This is just an example. Traders looking for more time could consider bull call spreads in June, or even December. If you have a greater risk tolerance, there are additional opportunities trading the futures, although you will need to be able to handle larger swings to avoid being squeezed out too early. If you are interested in trading gold, I suggest discussing an appropriate strategy with a knowledgeable broker. The brokers at RJOFutures are familiar with my strategies and my current recommendations. They can help you construct a strategy appropriate for your account size and risk tolerance.

About Today's Author:

Chad Butler is a Senior Market Strategist with RJOFutures, a division of R.J. O'Brien. His 16 years of market experience includes option spread trading, diversified trend following, and development of a number of index arbitrage programs. Chad’s published work appears in McGraw-Hill's Complete Guide to Single Stock Futures, Futures Magazine, and other trade publications.  He currently writes for various commodities newsletters, including RJOFutures MarketNews and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.