Is the Divergence in Gold an Opportunity?

Gold has drawn my attention this month, not just because of the rise, but the conditions from which the rise is occurring. I pride myself on being a student of intermarket relationships within the markets. One of the key pillars of intermarket analysis is the understanding of the inverse correlation of the U.S. Dollar to commodities. This could not have played out in a more clear way in the second half of 2014. July 2014 marked the bullish breakout of the U.S. Dollar and marked key commodity downturns in oil, copper, uranium, iron ore, gold and many other commodities. This marked a distinct bear market drive in almost all commodity based stocks.

As the U.S. Dollar rose throughout the second half of 2014, gold declined $200.00 an ounce from $1340.00 down to a low below $1150.00. But the New Year has brought about an interesting divergence. Driven by 1000 pip ($0.10) drop in the Euro, the U.S. Dollar has been very strong to start the year. This has caused a further $10.00 decline in oil prices and a $0.40 further decline in copper prices. With all things considered, the correlation in gold would have naturally allowed it to weaken down to the $1100.00 area. But it didn’t.

Instead we have seen gold stabilize and bullishly advance over $100.00 an ounce over that timeframe. These types of divergences draw my attention. This implies to me that the uncertainty in regards to a global recession and new ECB quantitative easing policies is drawing attention to gold as a hedge. As we now see zero to negative interest rates in the stable parts of Europe, holding 0% yielding gold bullion is a viable asset to hedge currency risk.

It is premature to be hyping a new gold bull market, but with gold and gold stocks being so depressed over the last 3 years, there may be room for them to retrace some of the overdone selling. The traditional way for investors and traders to participate in a trade like this is to buy a gold ETF like the iShares Gold Bullion ETF (CGL) and/or the iShares S&P/TSX Global Gold Index ETF (XGD). My observation as a trader is that the ETFs alone do not make the trade asymmetric enough. This is where I like to consider an in-the-money call option as a high delta way to participate.

Let’s compare the purchase of shares vs. call options with a $4.00 rise in the XGD stock.

• 1^st investor buys 1000 shares of the XGD for $11.34 or $11,340.00 investment. The investor has an undefined downside risk if the trade idea is wrong. If the stock was to rise to $15.34, the investor would be sitting on $4,000.00 in paper profits.
• 2^nd investor buys 10 March $10.00 call options for $1.57 or $1,570.00 which gives the investor the right to buy 1000 shares over the next 2 months at $10.00 per share. If wrong, unlike the undefined risk of the stock investor, the absolute worst loss the investor can incur is $1570.00. If the stock was to rise to $15.34, the call would have a $5.34 intrinsic value. This would be a $3.77 profit per share or $3,770.00.

Many traders like to look at the option trade as a 200% gain, but I don’t look at it that way. I look at it from the perspective that I was able to get an almost dollar for dollar participation (high delta), while being able to manage and define my risk. In March, the investor has the choice to take profits or to exercise the calls and take ownership of the ETF for the long term. To me, this represents a compelling alternative to just buying the stock.