By: Steve Smith
Gold prices have been sliding for the past few months but the selling pressure accelerated this week following Wednesday’s FOMC meeting when Yellen & Co. indicated they plan on hiking rates three times during 2017.
Higher rates take investment dollars away from the inert metal, which has no cash flow and offers no yield. And the need for gold’s role as a hedge remains muted along with inflation expectations.
Looking at the SPDR Gold ETF (GLD) we can see shares broke important support at the $115 level following the election and this week’s gap down places it right at longer term support at the $107-$108. It would appear gold is now at its make or break moment.
The sell-off in gold has also not surprisingly been accompanied by an increase in bearish sentiment and short positioning. As you can see from this chart, Commitment Of Traders is now its most bearish in over three years. This type of extreme can lead to a short covering rally if gold holds the current levels.
Another factor weighing on gold has been the rise in the U.S. dollar. Since gold is based in dollars the strong dollar makes it more expensive for foreign buyers such as China and India which use gold as an alternative currency.
As you can see the dollar/gold ratio is now at an important inflection point. I think the risk/reward favors a near-term pull back in the dollar which would be bullish for gold.
Lastly, we see the velocity of the recent selling has pushed gold to an extreme oversold condition. In the past such levels have provided reliable buy signals.
This all adds up to what I think presents a decent risk/reward for a short-term bullish trade in gold. I would use a basic vertical call spread in the January expiration. I’d look to buy the 107 calls and sell the 110 calls for a $1.30 net debit. This provides a nice low cost, limit risk, and the possibility of over a 100% gain.