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Hedging Gold Prices

How to Trade Gold from Here...

Written by Brian Hicks
Posted August 25, 2011

Editor's Note: A day after I wrote this article, gold pulled back some $60, confirming my downside call.

While the fall may not be over, there's a simple way to profit no matter what happens over the next few weeks.

 

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I'm just as bullish on $2,000 gold as I was with these picks in early August 2011:

  • SPDR Gold Shares (NYSE: GLD) position hit $184, a 13% gain.

  • SPDR Gold Shares (NYSE: GLD) December 2011 161 calls were up 203%.

  • Yamana Gold Inc. (NYSE: AUY) position hit $16, a 17% gain.

  • Newmont Mining Corporation (NYSE: NEM) hit $63.55, a 13% gain.

  • New Gold Inc. (NYSE: NGD) nailed $13, a 17% gain.

  • And Randgold Resources (NASDAQ: GOLD) had hit $114, a 24% gain.

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And gold still has room to run...

It's still pricing in a European version of Lehman. QE3 could be announced on Friday (unlikely). Demand is skyrocketing. Central banks around the globe are still buying. China and India are buying. Economic growth is stalling. There are signs of debt contagion in the euro zone.

And rising tensions in the Middle East are still sending speculators into the safe haven of gold.

But We Have To Be Realistic Here...

Gold has simply run up too far, too fast. It's up close to 35%, or $500, since January 2011. And it's up close to 18% in just the last few weeks.

Heck, it broke $1,900 the other night, less than two weeks after hitting $1,800.

gold chart 082411

The herd is far too bullish. Gold margins could get hiked again. It's technically overdue for a significant pullback on over-extended conditions. Just look at the Bollinger Bands, RSI, and MACD reads. And like I noted above... gold has rallied too far, too fast.

Look, you can't be afraid of going short here – even if the herd suggests doing the opposite.

Over the near-term, gold will face selling pressures.

But you also want to be well-hedged for further upside off the dips. Because another parabolic move is likely as central banks are still buying gold, as money managers boost their gold allocations as high as 15%, and as global economic tensions persist.

Do yourself a favor here. Stop chasing gold. Wait for the pullbacks to buy more. Don't do what the herd is doing. And in the meantime, hedge for gold's downside.

Hedge for The Correction...

If you're hedged for the correction, you're protected on the downside. And you're in good position to profit from the next leg up.

Gold fell to around $712 in 2008 after peaking above $1,010. Any investor that was hedged could have exited the short side, and used the funds to increase their bullish position in gold, as gold would run to $1,900 from $712 in just three years. And here's how you would do it...

You'd buy the SPDR Gold Shares (GLD) November 2011 175 calls (GLD111119C00175000), for example, while also buying an equal number of November 2011 170 puts (GLD111119P00170000).  Note: Options readers are raking in big gains in under two days from a similar position.

That's Also Known as a Strangle

Like you do with a straddle trade, a strangle also involves buying a call and a put option, both of which have the same expiration month. But there are two main differences...

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The options have different strike prices.

Unlike straddles, where you're picking at-the-money call and put options, strangles usually involve buying options that are out-of-the-money. And because they're cheaper, it means the cost of a strangle is less than a straddle.

But this cost saving upfront does come with a catch: Like the straddle play, you're still looking for the underlying asset to make a big move, but because the options are already out-of-the-money when you buy them, you need to see a bigger move than you would with a straddle.

The upside, however, is if that happens, you'll be looking at bigger profits.

The main reason for entering a strangle trade is the same reason why you'd execute a straddle: You're not sure which way the asset will move next, but you are sure that when it happens, it will be a big move.

Look, I know options seem scary. But they couldn't be easier. They couldn't be more profitable.

Stay Ahead of the Herd,

Ian L. Cooper
Analyst, Wealth Daily

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