Fed Hikes and Their Impact on Gold
When the first hike was delivered, along with the intention to deliver 3-4 more, gold prices were hovering above $1000. Gold now sits over $100 higher than it was at the time of the first hike, having rallied to $1375 when hikes were taken off the table. In our view one hike will see gold test $1000, two will see $1000 break, and three hikes would see $720 tested.
A slide in the yellow metal back to $1000 would put significant pressure on the mining stocks, which enjoyed a spectacular bounce over 2016. The HUI index was around 100 when gold was around $1000. Perhaps it was oversold at those levels, but that just proves how oversold miners can become; if they have done that before they can do it again. $1000 gold should certainly pressure the HUI index below 150, and if gold slides further below $1000 then gold miners will likely break the support at 100 on the HUI – therefore halving in value from current levels.
When the first hike was delivered, along with the intention to deliver 3-4 more, gold prices were hovering above $1000. Gold now sits over $100 higher than it was at the time of the first hike, having rallied to $1375 when hikes were taken off the table. In our view one hike will see gold test $1000, two will see $1000 break, and three hikes would see $720 tested.
The Miner’s Relationship with Gold and Equities
A slide in the yellow metal back to $1000 would put significant pressure on the mining stocks, which enjoyed a spectacular bounce over 2016. The HUI index was around 100 when gold was around $1000. Perhaps it was oversold at those levels, but that just proves how oversold miners can become, if they have done that before they can do it again. $1000 gold should certainly pressure the HUI index below 150, and if gold slides further below $1000 then gold miners will likely break the support at 100 on the HUI – therefore halving in value from current levels.
There is an argument that gold mining stocks will outperform gold this year as the stock market in general rallies. However, there are two key points to consider here. Firstly, when the stock market plummeted in January last year, gold miners enjoyed strong gains as gold prices rallied. Therefore, miners are more tied to the price of gold than the level of the S&P 500. Secondly if the Fed delivers multiple hikes this year, this will cap the stock market rally. The better the condition of the economy, the stock market and financial conditions, the more likely more hikes are. Therefore the hikes will cool the stock market rally, and could even reverse it. That would create yet more downside pressure on gold miners.
Our Trading Plan
As with any trade, the most important aspect is timing. Being too early is the same as being wrong. We are not shorting gold miners at this stage. Our plan is to wait out Q1 (just another couple of months) before beginning to layer into a core short position on the sector. As we approach the June FOMC, if multiple hikes are still looking likely, we will be aggressively short the gold mining sector into the second half of 2017. This also coincides with a seasonally weak period for mining stocks, from May through the European summer.
We would express our view and execute our short exposure via options. Even at current levels, the risk reward is attractive. For example, the low in GLD (NYSE:GLD) was around $100. One can speculate on gold making new lows by say $50 by the end of the year, by using options on GLD. Buying GLD December $100 puts and selling $95 puts against them costs $0.70 with a maximum upside of $5.00, a potential return of 600%. The risk-reward dynamics on gold miners appeal even more, despite a fall in liquidity for options on GDX (NYSE:GDX). The low in GDX was around $12.50. On can speculate on GDX making new lows by purchasing January 2018 puts with a strike of $13, and selling $11 puts against them, for a net cost of 18 cents. This spread could be worth $2.00 if GDX was $11 or lower by this time next year, a return of over 1000%.
In summary, the gold mining stocks are extremely vulnerable to a wave of selling as a result of multiple Fed hikes this year. Whilst perhaps not a trade for right now, the risk-reward offered in long dated, far out of the money puts both on gold and gold miners is a standout. To see what trades we are making and when, please visit subscribe via either of the buttons below. We intend to pull the trigger on these types of strategies over the coming month or so. Unless one holds the view that the Fed is not going to hike in 2017, then buying downside protection on gold miners, as a standalone trade or as a hedge against existing holdings in the sector, could be the trade of the year.
Disclaimer: SK Options Trading makes no guarantee or warranty on the accuracy or completeness of the data provided. Nothing contained herein is intended or shall be deemed to be investment advice, implied or otherwise. This letter represents our views and replicates trades that we are making but nothing more than that. Always consult your registered advisor to assist you with your investments. We accept no liability for any loss arising from the use of the data contained on this letter. Options contain a high level of risk that may result in the loss of part or all invested capital and therefore are suitable for experienced and professional investors and traders only. One should be familiar with the risks involved in options trading and we recommend consulting a financial adviser and/or viewing the SEC Options page if you feel you do not understand the risks involved in options: http://www.sec.gov/answers/options.htm