Metals Market Mania

drew-shaw2by Drew Shaw

Metals prices have been soaring, and gained steam after the U.S. government approved a two-year extension of Bush-era tax cuts this week, which had been set to expire. If you are an investor who keeps waiting for a major pullback before buying precious metals, you probably aren't finding many opportunities to do so. But there are strategies that still allow you to get involved in these markets no matter which way they are headed, using futures and options.


On Tuesday, December 7, COMEX gold futures rose to an all-time high of $1,432.50 an ounce. Silver futures hit a 30-year high above $30 an ounce, and copper futures hit a 31-month high, trading as high as $4.1315 per pound. These and other precious metals-namely platinum and palladium-have seen strong gains this year and are available for trading via various futures and options strategies.

We have seen some mild corrections in metals, but they haven't lasted very long. To fight inflation, China has enacted tightening measures, which have created dips in metals. Copper in particular came crashing down after the People's Bank of China raised its key interest rate to 5.56 percent in a surprise announcement in October. China's futures exchanges subsequently raised margin requirements to put further pressure on commodities prices..

China is a major commodity buyer in the global economy, and high prices are undesirable. It's thought China will likely undertake more tightening measures to make commodity prices drop again. This is a big factor to keep in mind as an investor or trader in these markets. The China Securities Journal ran an article this weekend heightening speculation that another rate increase could come sooner rather than later, stating the "timing was right" just ahead of the next release of the country's consumer price index report. Let's look at some specific markets, and trading strategies to consider.

Gold

Gold has been a phenomenal investment over the past decade. Anyone who had purchased gold since 2000 has seen a fantastic return. Gold was a bit choppy during the financial market collapse in 2008 – 2009, but the trend has been almost straight up over the past decade, continuing to extend record highs. I don't see it stopping soon, for many reasons. Gold is a big component of many commodities funds which investors use to diversify their portfolios; investors look to gold as a safe haven investment, and investors purchase gold to protect against inflation. The market has been making higher highs and higher lows, which is a bullish technical sign.

Trading Strategy

I frequently get calls from clients or potential clients who wish to buy gold, but want to wait for a pullback because they feel it's overpriced at current levels. Then the pullback never comes. Many analysts have said gold is overvalued; yet it keeps moving higher. How can you position yourself to gain if gold moves up from current levels, and potentially own gold at cheaper levels? You could consider the following options strategy, which I will outline.

Buy an April 2011 gold 1450 call
Sell an April 2011 gold 1500 call
Total cost of about $1300 (as of 12/8/10), not including your commission charges.
This is a bull call spread.

Sell a 1230 gold April put and receive $1400 in premium. You keep the premium for bearing the risk of selling the put option (a "naked" option). So you are netting $100 on this trading strategy overall.

If this trade hits our best-case scenario, your maximum profit would be $5,100, not including your commission charges or any other trading costs. These options expire on March 28, 2011. Gold must be at above $1,500 at expiration for this to occur.

If the price of gold were to fall below $1,230, your calls expire worthless, and you would be assigned a long futures position at $1,230. If you want to own a gold futures contract at this price, this strategy may be worth considering. However, I recommend you work with a professional if you are not familiar with options, and/or the possible risks. If gold started to fall after you were assigned the long futures position, your losses of course could be substantial.

But what if gold doesn't fall to $1,260? Let's look at possible outcomes, and the objective to reach our maximum profit potential.

If gold stays above $1,230 at expiration, you break even. You don't gain or lose. If gold is trading above $1,450, then this position overall is profitable. For every dollar the market moves above $1,450, you pocket $100 on your bullish options position. You still keep the premium on the 1260 put sold, but it expires worthless and you won't be assigned a long futures position.

We can see how this trade works on a graph. If gold is trading above $1,450 at expiration, you will be profitable. Between $1,230 and $1,450, you break even, move on, and look for another opportunity. If gold is under $1,230, you lose $100 for every dollar below that level.

If you were to go long a futures contract at $1,260 (if you are assigned a position on your 1260 put), your maximum risk on the downside is if gold fell to zero. It doesn't seem likely gold would be given away for free, but that's the worst-case scenario. On the flip side, your reward is then essentially unlimited on a move higher.

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I consider this overall to be a lower risk strategy than simply going long gold at present levels. You can replicate it in virtually any market. If you aren't comfortable with options or with owning a highly leveraged gold futures contract, there are still ways to participate in this market. There are mini-gold and micro-gold futures contracts, which are tailored to smaller investors with smaller capital requirements.

Silver

Unlike gold, silver has industrial uses. Silver has historically traded below $10, but has moved up to the $20 – $30 range in recent months. Silver is an extremely volatile commodity. It's a great trade if you are on the right side, but it can be very painful if you are not.  Fundamental reasons don't always drive silver ups and downs the way you might expect.

For example, in November, the CME Group/NYMEX exchange significantly increased the margin requirement for silver, and it caused the market to drop about $3. This is the "good faith deposit" traders must put up to enter or maintain their leveraged positions. The market's reaction to this change gives you some indication of the make up of the market participants. Hedgers are not likely to get pushed out of the market by this type of event, as they own the physical. Speculators do not own physical, and are forced to sell out of their positions to raise capital if they can't meet the new margin requirements.

Exchanges increase margin requirements for two reasons. When the price rises, more capital is needed to purchase the commodity, so it makes sense to increase margins. You need more money to put down to purchase it, just as if you'd need more money to put down on a higher-priced home than a lower-priced home. Margins also increase when volatility in the market is high, due to the increased trading risk. Traders need to be prepared for potentially big drops on any given day.

Copper

Copper has been particularly hot in recent days. Goldman Sachs said copper is likely to be one of the best-performing metals, and J.P. Morgan is in the process of launching a new copper-backed exchange-traded fund. Copper does not have a precious metal component such as gold and silver-it's purely industrial. If industrial demand picks up, so should copper prices. Copper prices tend to reflect the health of the global economy. There is speculation right now of potential copper shortages, which would of course support higher prices.

While I think there is still a lot of opportunity for copper to continue to move up, there is also a strong possibility for a rapid decline from current highs. I can see a fall possible to $3, which could be very costly if you are long copper at current prices. This being the case, you might consider hedging strategies. An options strategy similar to what I have outlined for gold can be applied to copper as well.

Platinum and Palladium

Gold and silver aren't the only precious metals you can trade. Platinum is a precious metal with industrial uses as well, and it should be on traders' radar screens. Platinum has previously rallied to over $2,000 an ounce, and is currently trading just above $1,700. The majority of its industrial use is in catalytic converters, so when auto sales rise or fall, platinum prices will tend to rise or fall as well.

Palladium is a similar metal to platinum, but is found in a different region of the world. Palladium is primarily found in Russia while platinum can be found in South Africa. From 1998 – 2000, palladium spiked to above $1,000 an ounce. Platinum didn't see the same type of gains. Russia had delayed palladium shipments, and there was little available supply. We had a shortage in palladium, but not in platinum.

Let's look at all the precious metals, and see how they compare on a chart. The white line represents gold, the green line palladium, the yellow line platinum, and the red line silver. Gold has moved from $1,100 – $1,400 and silver from $17 – $29. We have seen palladium nearly double in price, but platinum has not had the same price action, moving from $1,500 – $1,700. Platinum has been lagging. Taking all the moves into consideration, I think there's a good opportunity in platinum in particular among the precious metals.

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Drew Shaw is a Market Strategist based in Lind-Waldock's Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at [email protected]. Visit Lind-Waldock in Canada to learn about trading commodity futures and options, at www.lind-waldock.ca.

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