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By: Costas Bocelli — May 14, 2010

How Far Can Gold Run and What to Do About It

Economics, when stripped down to its purest form, is simply the attempt to satisfy unlimited wants with limited resources.  The supply and demand for commodities and natural resources are front and center in our daily lives. 

Gold has and always will be an important commodity in economies and financial markets.  It is the true gauge of worth and value.  Gold is a hard asset, and it is tangible, making it the ultimate flight to quality asset to investors.

The US Dollar is currently the world’s reserve currency, but Gold recently has become an alternative and more significant player looking to take the global lead.  Gold, which is denominated in US Dollars, has been bucking the long term notion of the inverse correlation between the two.  In fact, both the US Dollar and Gold have been breaking out sharply to the upside.

What does this mean?

The main feature of Gold is that it's an inflationary hedge against currencies.  As currencies debase or devalue, it makes this hard asset more expensive to acquire.  With both the US Dollar and Gold rising, that could infer that global currencies are breaking down faster than the US Dollar is rising, and the flight to the asset is disregarding the Dollar premium as a means to diversify risk.

Below is a chart of Gold Futures.  It recently set an all time high of $1242/ounce, surpassing the previous all time high set in December 2009 of $1220/ounce (denoted by the red line).  The diagonal channel shows the break out.


The recent spike in Gold is clearly attributed to the global debt crisis, currently affecting Europe.  Last week, the Eurozone partners, IMF and the European Central Bank put up a $1 trillion guarantee (750 billion Euros) on top of the 150 billion dollar bailout devoted to Greece.

These actions, which were needed to stave off a systemic financial crisis, have significant effects that are being seen with the surge in Gold.  Basically, this action is devaluing the Euro currency, causing inflation in the money supply from the monetization of debt.

If the injection of funds is not enough to halt the contagion spreading to the other countries, more money will have to be created, putting further pressure on currency valuation and increasing the value of Gold.

Where does Gold go from here?

Based on the huge debt load of the Eurozone and the austerity measures put in place, I don’t see this easing up anytime soon.  Commodities are a momentum vehicle, and this upward trend can stretch to the edges.  Crude Oil in 2008 broke out from 90, soaring to 150 in months (66% gain).

A major factor that can push the parabolic rise in Gold is if the debt contagion cannot be contained or spreads, primarily to the United States.

The United States debt burden is increasingly becoming a concern.  The deficit in 2009 was $1.4 Trillion and it looks like the 2010 full year deficit projection is going to top it at $1.5 Trillion.  Keep in mind that 2010 is supposed to be the recovery year that has been confirmed recently by all the great economic data and corporate earnings.  How much better does it have to get where we can stop the massive deficits?

In the near term it is reasonable to say that Gold will try and test $1300, especially if the Euro and Pound Sterling remain weak.  The wild card is the US Dollar.  If the contagion spreads and begins to affect the US Economy, another round of quantitative easing may be needed.

The Federal Reserve cannot allow Treasury Rates to rise sharply without a strong GDP because of the mountains of debt that need to be continuously refinanced.  The Fed would be forced to purchase more Treasuries to keep the rates low, thus monetizing the debt.

The US Dollar will suffer the same effects of inflated currency and devalue, especially if investors rotate out.  The rotation would go to the other currency reserve, Gold.  If, and this is a big if, the US Dollar retraces the gains of the last 5 months and retests the 75 level, you could see Gold at $1750-$1800/ounce.

The implied volatility of Gold and Gold derivative products place a 5% chance that Gold could trade that level in the next 12 months.  It will depend on how deeply this debt crisis affects the global economies and how much investor fear surges into the crowded trade.

How can you play this?

For the time being, the bullish gold trend and bearish global currency trend should continue.  GLD is an ETF that correlates with Gold Futures.  To capture further upside appreciation with GLD around 120.50, you can purchase July Calls with a strike price range between 115 to 120, depending on how much risk and delta exposure you are comfortable with.  The conservative approach would be purchasing a Vertical Call Spread, such as the July 120 125.  This strategy has less risk, but it will cap your profit potential. 

The advantages of both option strategies is that if Gold continues higher, the position can be rolled to higher strikes.  Rolling will allow you collect some of your profits while maintaining the long position and keeping the risk minimized.  As July expiry nears and the bullish pattern is intact, the position can be rolled out in time as well.

Also, consider premium collection bear spreads on the weakening currencies such as the Euro.  FXE, an ETF that tracks the currency, is trading around 126.  Consider selling the 126 131 Call Spread for 1.75 credit.  If the Euro stabilizes or trades lower, the 1.75 credit can be used to offset some or most of the premium on the Gold trade.

Another advantage to this coupled position is you are on the right side of the trend and your total risk is defined by the purchase price of the GLD Calls or GLD Call Spread and the sale of the Bear Call Spread in the Euro. (The call spread can only expand to the difference between the strikes, 5.  You sold the spread for 1.75, so the risk is 3.25 per contract).

Time will tell how long this trend will last and how far the moves will be, but for the time being, the global debt problems will not go away overnight.

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