Is Gold Breaking Out of its 4-Year Consolidation?

Over the last few years I have not been shy about my conviction that the gold bear market has ended.  There is no denying that the December 2015 lows for gold bullion at $1050.00 are now history, but the enthusiasm for the shiny metal has been left for the diehards as most of the speculative money has turned its attention to cryptocurrencies and cannabis stocks.  Will the glitter return to gold and usher in a new opportunity for investors to profit? One Wall Street legend certainly thinks so.

Jeffrey Gundlach from Doubleline Funds, who has been crowned the new “Bond King” has taken a firm stance on the metal.  Speaking at John Mauldin’s Strategic Investment Conference back in March, he made a strong case for the yellow metal.

Here is what he had to say:

We’re also at the juncture in gold, not surprisingly, because it is negatively correlated with the dollar. We see that gold broke above its downtrend line, it’s got the same look. But now we see a massive base building in gold. Massive. It’s a four-year, five-year base in gold. If we break above this resistance line one can expect gold to go up by, like, a thousand dollars. Will it happen? Well it’s not happening right now but it’s a very interesting juncture. It’s a great time to be buying gold straddles. Because one way or the other this baby’s got to break in a big way.

Source: tradingview.com

It’s a great time to buy gold straddles? 

While Jeffrey’s call on gold appears bullish, what he more accurately is suggesting is that gold is winding up for a very big move and that move could arguably be a break lower as easily as a break higher.  I found it very interesting that he referenced an options straddle as a way to implement the trade. Those not familiar with strategy can find a great summary provided by the Montreal Exchange HERE.

For more sophisticated traders, turning to the options markets on gold futures is always an interesting consideration, but for most retail investors, they turn to the derivative of trading their view on gold through the gold mining companies that readily trade on the main stock exchanges.  Does the same opportunity apply to gold miners?

I would argue that the opportunity is even more asymmetric.  The gold bullion price rally in the first half of 2016 saw the price rise from $1050.00 lows toward $1375.00 for a 30% rise.  During that same time, the iShares S&P/TSX Global Gold Index ETF (XGD) more than doubled in price rising from the low $7.00 range to almost reaching $18.00 a share.

The observation being that the miners have through history demonstrated to be more volatile and more responsive, which is ideal for a trader opening a option straddle position.  Obviously, the implied volatility being priced into the option partly discounts this, but it does not change the fact that an extraordinary move in gold, to the magnitude Jeffrey Gundlach suggests, presents a compelling speculation for big returns.

Assuming an investor was motivated by Gundlach’s bold call on gold and wanted to put on a straddle, how would the trade potentially look using iShares S&P/TSX Global Gold Index ETF (XGD).

Breakdown:

• iShares S&P/TSX Global Gold Index ETF is trading at $12.00 (April 20, 2018)
• The March 2019 $12.00 call option is $1.20
• The March 2019 $12.00 put option is $1.15
• The net cost of the straddle (buying the call and the put) is $2.35

The first observation is that it appears to be a rather large percentage outlay at around 20% of the cost of the shares.  But that needs to be put into context.  As seen on the chart below, that the implied volatility on the XGD options remain on the bottom of the 1-year range, which at the most basic level suggests more favorable volatility risks as a spike in implied that normalizes back to the historical mean would improve the profitability of the straddle.

Source: Interactive Brokers

The other consideration is putting the context of a potential range of a breakout in the XGD.  While the 2017 calendar year was defined by a relatively narrow range of $3.00 (between $11.41 low to $14.51 high), the 2016 year could arguably be a more accurate example of what the XGD is capable of if a breakout was to occur.  In 2016 the XGD had a +$10.00 range (between $7.68 low to a $17.70 high).  Will Jeffrey Gundlach’s bold call be proven right?  It will certainly be one of the more interesting themes of the year to watch.