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Going For Gold in 2014

This Trade Alert is lengthier than you've become accustomed to, as we've combined some very interesting data and ideas into one short report. The first thing that we want to bring to your attention is a setup in the gold markets that we believe warrants investor attention. Tres Knippa, a friend and floor trader at the CME, was made aware of it by one of his clients. Subsequent to my initial discussions with Tres, I've dug deeper into what he shared with me with our own Brad Thomas, editor of our Capex Trade Alert service. In this Alert I bring it to your attention, together with our thoughts on how best to participate. That will lead us into the second idea, which is how Brad believes we should trade it. Tres shared with me what he calls The gold spread trade... Traders familiar with gold futures contracts will understand what inverted means, but for those who are not aware, inverted refers to a situation when the front month of futures contracts trade at a premium to the back months. gold for delivery in February, for example, trades at a premium to gold for delivery in April. Gold Futures typically do not carry a premium in the front months. This is because there are costs to storing and holding inventory. The same is true of other commodities such as wheat, corn or crude oil. In the case of gold, holders must pay storage fees, and as is true with holding any commodity there is an element of time value of money. The most plausible reason I can think of whereby gold should trade at a premium in the front months is if there was an expectation of a large supply coming down the pike in later months, but since gold supply is reasonably finite this doesn't appear to be the case. I have not found any information leading me to believe that a large supply will hit the markets any time soon. The IMF or a central bank could sell a large amount of gold into the market, however this is typically reported ahead of schedule, and we don't have any such event on the horizon that we're aware of. When he noticed this setup in the market, Tres, pulled up a chart of the historical gold spread. This is the spread of the front months to the back months. He calls it the seahorse chart. You'll notice a predictable pattern. The chart below shows the expiring month of gold traded versus the next deliverable month of gold for nearly 4 years.

Notice the consistent pattern. The spot month of gold gains ground on the deferred months, every single month. The question is why? To answer this let's rewind to two years ago. At the AmeriCatalyst conference Kyle Bass explained why, as a fiduciary, he advised the University of Texas to take delivery of $1B in gold from the Comex. Here is a link to the video: Kyle talks about how the Comex is a fractional reserve exchange, which means that there are many more futures contracts traded than the Comex can actually deliver in way of physical gold. In other words, if all or even a fraction of the trades that are being placed were actually to be settled in physical gold, it would in fact be impossible. Anyone who is familiar with modern financial markets is well aware of the fractional reserve system, however this is the backbone of Tres thesis on the above gold spreads, and why they are acting in the fashion they are. The seahorse chart is, in his opinion a graphical representation of the fact that as gold gets closer to delivery, the risk to the shorts increases. This risk increases because shorts know that the gold is not there for physical delivery, and as such it pays to close out the trade and not be forced to settle physically. Simple risk management would support this theory. What would happen if the holders of gold futures contracts actually stepped up to take delivery of the product? This next chart bolsters the case. It is a graphical representation of the amount of gold in Registered Comex inventory. What is evident from the chart below is that the amount of physical gold inventory at the Comex is going down. According to the latest numbers registered inventories are now at 402,000 ounces. At $1,200 per ounce this represents $504 Million in

available gold for delivery. Look at the figure 3 at the bottom of the 4 charts. This represents the amount of open futures contracts versus the amount of physical gold available for delivery. Think of this as Owners per ounce.

As you can see, the owners per ounce has risen dramatically over the last year. This may well be why the gold spread looks the way it does. This is why shorts roll positions OUT of the front month as delivery approaches. The shorts don't have the physical gold to deliver on expiry and cannot be sure that longs won't demand physical delivery instead of cash settlement. Simple risk management tells you: DONT BE FORCED TO SETTLE PHYSICAL!!

How to trade this situation

Whether gold rises or falls is not the gist of this trade. What appears clear is the trading opportunity at hand. We simply need to be positioned for an outsized move should it take place.

Therefore, the opportunity is in the spread itself. The spread market is very liquid and the margin required to hold the spread is very low. The margin requirement for example on 10 spreads is $1,380 as set by Comex. Extracting 10 ticks out of this market every two months (gold for delivery is on 6 trading months of the year) would yield $1,000 in profit, or $6,000 per year minus commissions and fees. We can see that 10 ticks would be achievable based on the seahorse chart. Now take a look at the next chart below. This is the chart of December 2013 vs February 2014 Gold. This spread blew out into the inverted zone running 21 ticks premium as delivery drew near. This means that an adept trader properly positioned could have grabbed 30 ticks out of this spread rather than 10.

What is possible under a short squeeze scenario? In the above illustration gold futures in the spot month ran 22 ticks premium in the spot month. 22 ticks represents a $2.20 premium for the spot month. Now I want to consider what is a real possibility in the coming years. The COMEX has rules covering position limits for individual traders. The position limit for gold is 3,000 contracts. This means that if one entity bought 3,000 contracts and took delivery, that entity would be standing for 300,000 ounces of gold. This seems like a lot until you consider that the total deliverable supply of gold is just 417,000 ounces. One person or one entity could take 71.9% of the deliverable supply? Where could this spread trade to if just two entities stood for delivery? Obviously we don't know exactly, but we do know which side of the trade we want to be on.

Now lets be clear, if a short squeeze never happens, that is still ok. The spread existing on the front month to the back months as shown in the seahorse chart will still be tradable as long as it lasts. I'd like to point out that Kyle Bass made an interesting comment in his interview for the AmeriCatalyst Conference in 2011. He stated very clearly that the Comex was very hesitant to allow Kyle and his company to conduct an audit of gold supplies available. Hmmm..? As registered Gold inventory continues to work lower, one would imagine that traders carrying short positions will become increasingly less interested in holding positions to delivery, meaning that the entire thesis described above will not only remain in tact, but may well present an outstanding opportunity to profit from a short squeeze should one eventuate. From the look of the numbers that possibility seems to grow with each passing day. If you would like to discuss this trade with Tres you can contact him directly at: tres@shortjapandebt.com

Our Thoughts
Tres makes some great points, however having traded actively for many years myself I will say that amateurs can quickly and easily get themselves into trouble "playing the spread". It is not something that I would do personally unless I was both experienced, as well as trading full-time, which I no longer do. I Discussed this with Brad Thomas over the weekend and we both felt that the most favourable risk reward setup existed in trading options on the gold miners. This presented a less risky, less time consuming, less stressful setup. Furthermore, in a bull market the miners can and do move astonishingly quickly. For whatever reason right now the option implied volatility of the above mentioned trade that Tres brought to our attention is not reflected in the market. Before I present you with Brad's trade idea I'd like to refer back to a post we published recently on the site, in which our friend Mark Schumacher provided some very interesting statistics. The reason I present the data below will become clear as you we see how Brad is trading this. Average 3-year nominal returns when buying a down sector (since 1920s): Down Avg. Annual Return 60% = 57% 70% = 87% 80% = 172% 90% = 240% Average 3-year nominal returns when buying a down industry (since 1920s): Down Avg. Annual Return 60% = 71% 70% = 96%

80% = 136% 90% = 115% Average 3-year nominal returns when buying a down country (since the 1970s): Down Avg. Annual Return 60% = 107% 70% = 116% 80% = 118% 90% = 156% The full article can be read here. The above data is only useful if we know how to intelligently apply it in the real world. If not we simply risk being able to hold intelligent cocktail party conversation whilst being broke, which is really not particularly useful! If we look at the junior gold miners ETFs GDXJ and GDX we notice the following:

The high for GDXJ was reached at $175.76 on Dec 6, 2010. Today at $35.34 we're a whisker away from a stunning 80% collapse. In fact in December GDXJ hit $28.85, representing a loss of 83.6% from its highs. For GDX the high was reached at $66.69 on the September 8, 2011. Thus far the low has been at $20.39 on December 23, 2013, representing a 69% collapse. Today GDX trades at $23.36, representing a very respectable 65% wipeout!

Are the lows in? I have no idea. This is a game of probabilities, but once again take a look at what history indicates. Barrick Gold is a poster child for the gold miners. It has collapsed 76% from its highs in April 2011, to its low in Jul 2013 where it appears to have bottomed. We have in front of us a complete washout in the sector, combined with relatively cheaply priced option volatility. This is likely as close to perfect as we're going to find a trading setup. So, here's how Brad recommends trading it.

Trading the gold miners for outsized returns

Macro View: Bullish outlook on Barrick Gold (ABX). Timeframe: Long term (24 months). I continue to hold the view that there will be an ultimate price to pay for all of the unprecedented monetary stimulus and money printing that we have observed over the last 5 years across most developed markets. This ultimate cost will be inflation, with a resulting dramatic rise in precious metals.

If ever there was a time to invest in gold stocks now is probably the best time due to a number of factors: 1. Sentiment towards gold stocks is exceptionally bearish how much more bearish can sentiment become? 2. Given the above it is highly likely that this is the most under-owned that gold stocks have been in a couple of decades, with the result that shares of mining companies are likely to be concentrated in the hands of a relative few - where is the marginal seller of gold stocks going to come from? 3. Most gold producers are making losses, which suggests that the cost of producing gold is about $1200 an ounce how much below the cost of production can gold go before material shutdown of capacity occurs? 4. Fundamental valuations are exceptionally low with most of the big producers trading more or less @ book value are we likely to see any further compression of price multiples? Why ABX specifically? In essence while the price of gold has continued to fall over the last 8 months, Barricks share price hasnt, which suggests that Barricks stock price has probably found a long-term bottom.

Application of View: Long term OTM (out of the money) vertical call spread. It's a bull call spread - Jan16 expiry. The reason for the vertical spread is that option volatility is a little high and a vertical spread offsets the impact of high volatility to a large extent. Instrument: Jan16 expiration, 25/35 vertical spread (buying the 25 and selling the 35 strike calls) @ 1.50 or better. Outcomes: Assume that $1050 was allocated to this trade. One would purchase 7 spreads @ 1.50. At expiration if ABX was to close: 1. Below $25.00 loss = 100% 2. @ $26.50 - Breakeven 3. @ $28.00 profit of 100%

4. @ $30 profit of 220% 5. @ $35 profit of 567% (a maximum profit will be achieved if ABX closes @ 35 or higher) Below is the trade as it would appear on the Interactive Brokers Webtrader platform:

Risk Allocation: Allocate approximately 1% of risk capital to this trade. Hold until expiry or until the maximum profit potential has been reached. The Capex Trade Alert service, which Brad has been producing for us, will shortly go live as a paid subscription. We hope you will continue on with us when that takes place. For now it's still complementary, and we hope that you take full advantage of the information being provided, and like many of our members, profit from Brad's exceptional skills as a trader and money manager. Good Luck! Let us know what you think of this Trading Alert. Drop us a note at: admin@capitalistexploits.at - Mark and Chris
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