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Markets
Monday
Mar062017

Trapped Longs In Miners As Gold Poised For Fed Fuelled Fall

The Fed will hike rates this month and signal further hikes to come. Gold prices have yet to fully digest this reality, and therefore there is a strong case for a major move lower in the yellow metal. A Le Pen victory in France could derail the Fed’s plans for a follow up hike in June, but in the short term the gold market is vulnerable to a sharp move lower. There are a number of trapped speculative longs in the futures and mining stocks and we are approaching a period of seasonal weakness. We target a move to $1050 initially, and see merits in a larger move to $720 should the Fed persist with further hikes.

March Hike A Done Deal

The Fed speakers last week unequivocally signalled a March hike. Yellen’s speech to cap the week off confirmed this, and we therefore expect the Fed to hike at next week’s FOMC meeting. Although we still have an employment print before then, the Fed can look through the weakness of one print given the strength of the rest of the data and their clear preference to raise rates.

The Fed has made it clear that is never wishes to surprise the market with a hike. Therefore the explicit signalling last week was meant to prepare the market for a hike this month. Markets have adjusted, now pricing an 80% probability that rates will rise.

Even more importantly than signalling a March hike, the Fed speakers made it clear that more hikes are set to come. The last guidance we got from the Fed (in December) was for 2-3 hikes over 2017. However now that the Fed is taking the first opportunity to lift rates this year, there is a risk that they are now considering more than 2-3 hikes.

Whether or not these hikes will be delivered remains to be seen, but the first definitely will be, hence the risk profile has shifted in favour of more hikes rather than less. In fact, there are only a few scenarios that we see derailing a follow up hike in June.

Le Pen Could Stop June

The economic data is obviously very important to the Fed’s decision making progress. However economic data is often sluggish and given the solid backdrop of data over the last year, a few soft prints could probably be looked through by the Fed given their long term bias to move rates to a more neutral level. It would take a rapid deterioration in the data between now and June to stop the Fed hiking again.

However unlike economic data, a severe change in the geo-political landscape can happen very quickly. The prime candidate for a large disruption in the geo-political environment is the French elections. The first round of the 2017 French presidential election will be held on 23 April. Should no candidate win a majority, a run-off election between the top two candidates will be held on 7 May. It looks likely that we will go to a runoff and that Marine Le Pen, the National Front candidate, will be one of the two candidates.

Polls still show a Le Pen victory as unlikely, but anybody putting too much weight on polls after their woeful predictions in the Brexit referendum and US presidential elections, is being incredibly naïve.  We are largely ignoring the polling statistics. As far as we are concerned, we have a two horse race for the presidency and that means there is enough of a chance of a Le Pen victory to be concerned with, especially given the consequences.

Regardless of the precise probability, the risk is asymmetric into this election. Le Pen is a strong opponent of the Euro and advocates France leaving the common currency. She has pledged to take France out of the Eurozone and, unless the EU agrees to revert to a loose coalition of nations with neither a single currency nor a border-free area, to hold a referendum on France’s EU membership. Therefore this election is more important for the EU than Brexit. Britain held a referendum on EU membership, but if Le Pen is elected then France could leave the EU and Euro with no referendum. This would arguably signal the end of the European Union.

This is the biggest risk to our view on Fed policy. A June hike is off the table should Le Pen win. All hikes may be off the table. It would see us cut our short positions on gold. However, unless this happens, the path is clearly set for more hikes from the Fed and lower gold prices.

Multiple Hikes Will Cripple Gold

Gold has enjoyed a large bull run as quantitative easing programs around the world, particularly in the US, kept interest rates low and made the yellow metal a comparatively great investment. Whilst it’s been a stuttering start, the unwind of this easing and beginning of a tightening is underway. The tightening of monetary policy in the US will drive gold prices much lower.

We have not ever been, and will never be, perma-bears nor perma-bulls. We trade gold from a macro-economic viewpoint and at present the macro trend implies much lower gold prices. In fact, our best year on record (2010: +167%) came from being aggressively long gold in anticipation of QE from the Fed. Our second best year on record (2013: +93%) largely came from aggressive short positions in gold in anticipation of the tapering of QE programs by the Fed.

We are potentially at the very start of a large macro driven decline in gold prices. Multiple hikes from the Fed and potential unwind of the QE inflated Fed balance sheet down the road could see a multi-year bear market in gold. Looking years into the future is beyond our scope, but it is with high conviction that we express our view that multiple Fed hikes this year will drive gold prices to re-test the lows. A March hike should test $1125 and a follow up in June will question the $1050 support. If the Fed is still intent on further hikes, then $720 is not out of the question.

Seasonality A Further Blow To Bulls

The seasonally weak time of the year for gold, and gold miners is also upon us. On average over the last decade, gold has lost 3% in March. Whilst there is sometimes some fightback in April, the “Sell in May and Go Away” adage kicks in hard for gold and mining stocks. Gold mining stocks haven’t made gains in May for eight years, losing an average of 5.5% in May over that time.

These so called “summer doldrums” are often tough on the yellow metal and associated stocks. The pressure of Fed hikes over this period will only make this worse. Our preference is hold shorts over the next few months before re-evaluating following the June FOMC and towards the end of the European summer.

Momentum Is Gone

The yellow metal has been sluggish to react to the Fed’s signalling of a March hike. This is not out of the ordinary, with gold often slower to respond to changes in the macro landscape than larger highly reactive markets such as fixed income, which dominate much of the focus.

It has reacted enough to take the bullish momentum out of its sails though. Technically, gold has tested the $1225 support zone which we expect to break this week. The rising wedge formation so far this year has been broken, and gold looks primed for a $100 fall, with only minor support around $1185.

The loss of bullish momentum is evident from the declining RSI and a bearish MACD cross adds weight to the bearish technical arguments. We had been noting for the last couple of months that whilst gold had bearish fundamental pressure, the technical set up was bullish and gold had plenty of momentum. We now have a bearish technical set up to match the bearish fundamentals

Speculative Longs Are Trapped

At the end of February the speculative long positioning in gold jumped, as leveraged accounts increased their long exposure, attracted by gold’s bullish momentum. However such accounts will begin to cut their longs should gold lose its momentum. This week saw gold lose its momentum and therefore we expect to see these accounts sell their positions, especially ahead of the Fed hike, creating downward pressure on gold.

Chart from www.oanda.com

The price action in miners this week exposed just how long the market is in this sector. Speculative money has flooded back into miners after their speculator rise. At the end of January we wrote an article entitled “ Gold Mining Stocks Could Halve In 2017” and the sheer volume of negative feedback we received following this made the positioning glaringly obvious. Since then GDX is down -4.1%.

Whilst we could see a bounce in miners from here on a technical basis, it will be short lived. The trapped longs will be looking to sell into strength to lighten positions, as opposed to buying.  We will be initiating short positions into a bounce and still hold the view that gold mining stocks could halve in 2017.

Stay Short, Sell Rallies

Our own capital is at risk in all the trades we make. We are short gold with no intention of taking profits any time soon. We intend to stay short and sell rallies from here. Whilst we acknowledge the possibility of a long term move to $720 in gold, we are not yet positioned for such a drop. We are targeting a re-test of $1050 and have expressed our short via various option strategies. The specifics of these are available to subscribers only, so if you wish to become a subscriber please do so via either of the buttons below.

The main risk to our view is a Le Pen victory that rocks the Fed off course. Should the Fed remain on course then we will look to re-position for a major move lower in gold to $720 over the next year. Looking at the macro economic landscape, gold is simply the best asset to be short into Fed hikes, offering compelling reasons from a relative value, positioning and technical basis.

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Wednesday
Feb222017

Gold: Short End US Rates Matter More Than Long End Real Yields

In the years following the GFC, short end yields in the US were contained for an extended period of time as the Fed committed to keeping rates on hold. Given the static nature of the short end, and the shift of monetary policy implications further out the curve through QE programs, long end US rates became the focus. When discussing the drivers of gold prices, long end US real rates (the yield on inflation protected bonds) was the critical factor. However over the past couple of years, the Fed has hiked rates twice, and we now have live meetings with an active short end. This has reduced the impact of long end real rates on gold, and instead shifted the focus to the short end. We now form our view on gold prices overwhelming based on short end rates, as opposed to long end yields. Our bearish view on gold prices is derived from a Fed hike in June.

The Historical Correlation

Looking back at the relationship between gold prices and US real rates there is a solid case. We wrote about it at length through 2010-2012 ( The Key Relationship between US Real Rates and Gold Prices) and specifically how it replaced the typical inverse relationship between the USD and gold that had been observed in the past. We will use simple regressions from GLD, the gold ETF and TIP, an ETF that tracks the performance of TIPS – Treasury Inflation Protected Securities – in effect real yields. Over a long term time frame the regression appears solid, with an R-squared value of 0.7742 – meaning that 77.42% of the changes in the GLD price can be statistically explained by the change in TIP.

Readers will notice a “clump” of data that skews the regression line from what would be a very strong relationship. This strong relationship was particularly evident through to about 2013. Up until this point the world was very focused on QE and the short end rate mattered little as the Fed was on hold for the foreseeable future. Hence, gold and other assets were very closely related to the longer term real rates, since both the long end rates and gold were impacted in a similar manner by changes to QE programs.

Before the Fed started to taper QE and discuss rate hikes, US real rates and gold moved in tandem. The below chart, that excludes data from 2013 and later, shows that 96% of the changes in GLD can be statically explained by changes in TIP.  We discussed this at length, particularly in 2011 when the collapse in US real yields saw us take aggressive long positions in gold targeting a rally to $1800.

Then we had the “taper tantrum” as the Fed stopped adding to QE. The Fed also then began talking about raising short term rates at some stage, and it was during this period that the relationship between gold and US real rates collapsed.

Shifting to the Short End

The market’s focus shifted from the long end of the curve to the short end. Gold was suddenly being driven by rate hike expectations, not QE expectations. This has remained the case until today. From the start of 2013, just over 20% of the moves in GLD can be explained by moves in TIP. This is a huge drop from the 96% we observed 2005-2013.

After being dormant for so many years, the short end of the US yield curve is now very much active. We have had two hikes in the last 26 months and we have 2-3 more priced into the next 12mths. That means that the short end is now the key driver of gold prices, taking the place of US real rates in the longer end.

Looking at the relationship between SHY (an ETF that holds 1-3y Treasury Bonds) and GLD we can see that since the start of 2015 it exhibits a modestly strong 0.43 R-Squared value with GLD.

However what is more important is that this relationship is strengthening. With the Fed on a tightening bias, and 2-3 hikes priced by the end of 2017, short end US yield are the key part of the US bond market to watch. Plotting the same pair from the start of 2016 shows an R-squared that’s increased from 0.43 to 0.66. Of course this is still well short of the 0.96 we saw between US real rates and gold at the peak of their relationship, but nonetheless still an important trend to note. The relationship between US real rates and gold prices has significantly decreased, whilst the relationship between US short end rates and gold prices is steadily increasing.

If the Fed delivers more hikes this year, we could see further weakness in US short end bonds and therefore in gold prices. If Yellen does not come through with hikes, then short end US yields will fall, sending gold higher.

Trading the New Relationship

It is our core view that the Fed will not hike in March, but wait until June. Whilst gold prices are enjoying some temporary support from contained short end yields (with a March hike unlikely), once we move closer to June, and a hike becomes more likely, this will send US short end yields higher and therefore drag gold prices lower.

In the three months prior to the last two hikes, gold prices fell 10-15%. Using that as a rough guide, we see gold falling to between $1125-$1050 over the next few months. If US data improves, and the Fed delivered further rate increases in September and/or December, we will likely see another leg lower in gold through the major support zone around $1050.

Below $1050, there is not a lot of support until $720, which is why we view the risks as asymmetric in gold at present, and our biased to run short positions on the yellow metal.  Our core view is not for three hikes this year. Our core view is a hike in June and a 50% chance of another hike before the end of the year. However it would take no hikes at all this year to really push gold into a new bull market through $1400. One hike in June will see gold re-test the lows.  From there it does get very vulnerable from a technical and fundamental standpoint to the downside.

We are not perma-bears not perma-bulls on gold. We are simply a trading operation and therefore try not to be perma-anything. We trade gold from a macro view point, and at present we view the macro landscape as supportive of a June hike and possibly another later in the year. Given the current level of gold prices, plus the risk-reward in various long term option strategies we have discussed with our subscribers, we are bearish on gold at this point.

Our plan is to layer into a number of short positions over the coming month or two, having a substantial short position well before the June FOMC. To see what trades we are executing please subscribe via either of the buttons below. Regardless of one’s view on gold, the purpose of this article was to highlight the growing importance of short end yields in determining the gold price. At the same time, the importance of long end real yields is diminishing. Staying focused on the Fed, and building a view on gold from that, continues to be the optimal way to trade gold from a macro standpoint.

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Monday
Jan302017

Gold Mining Stocks Could Halve In 2017

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 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. 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 is 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.

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Monday
Dec122016

Buying Gold Into A Fed Hike: As Dumb As It Sounds?

The Fed will hike rates this week. The US Dollar is strengthening. Fiscal policy is about to ignite economic growth. The ECB has reduced rate of QE purchases. It doesn’t sound like now is the time to be buying gold does it? And yet, the setup is remarkably similar to this time last year, before the yellow metal put in a near 30% rally. What matters most is not what will happen, but what will happen relative to expectations. It is fair to say that the market has some lofty expectations built in at present, which is why it could be a case of buying the rumour and selling the fact over coming months.

+0.25% This Week Is 95% Done

 According to the CME’s FedWatch Tool, a 25bp hike this week from the Fed is 95% priced in, which is near enough 100%. So when the Fed hikes rates, how will the market react?

The hike has been so well signalled, and is so well priced into financial markets, that when it is confirmed it will have little impact whatsoever. So those arguing against being long gold this week as “the Fed will hike” are perhaps not fully considering the extent to which this hike is expected. What matters more is the tone surrounding the hike and the dot plot projection of future rate expectations.

The Fed has been emphasising its extremely cautious, data dependent stance for years now. Stability is one of their key concerns. They have not hiked through all of 2016, so are not about to signal a rapid series of hikes given economic data has been relatively stable. In fact, when the Fed hiked in December last year, the dot plot was lowered from the September projection. Whilst we are not expecting the Fed to lower the dots this time around, we see a very limited chance that the dots are higher. The markets on the other hand have aggressively increased their expectations for future hikes in the last month or so, meaning that no change in the plot could see them bitterly disappointed.

Greenback Rally Dependent On Hawkish Yellen

Gold prices exhibit and inverse relationship with the US dollar, particularly against the Japanese Yen. In order to the USD rally to continue it will take a hawkish Fed that signals further tightening over and above the markets current expectations. If the dot plot is unchanged, this could see the USD weaken and take gold prices higher.

The relationship between gold and USDJPY has become more apparent recently due to the widening interest rate differential between the two. The BoJ has pledged to keep its 10year bond yield near 0%, but US bond yields have risen significantly as the market bets on aggressive tightening from the Fed in response to inflationary fiscal policy next year.

Fiscal Policy Is Not A Light Switch

The market has grown increasingly confident of a sustained uptick in economic data, driven by upcoming “borrow and build” policies from the new administration. However, the market is placing little chance of anything derailing the programs and their impacts. Trump cannot simple flip a switch when he takes office.

Whilst aggressive US fiscal policy can be inflationary, the effects of such policies take time to feed through. Of course such policy still has to be proposed, agreed upon, and implemented. When the Hoover Dam project was announced during The Great Depression, thousands of unemployed Americans flocked to Nevada looking for work, shovels at the ready. They were bitterly disappointed when they learned that it would be years before any labour was required, since the dam still needed to be designed, construction planned, and materials sourced.

There is then yet another lag between the implementation of such projects and their impact being seen in economic data, then the Fed reacting to that data. Yet, the market expects a couple of Fed hikes to come next year – despite the Fed only just getting to its second hike eight years after the GFC.

It’s not about the end result. It’s about the result relative to expectations. Expectations are lofty, and markets are impatient. The market will react poorly to any delays in fiscal and monetary policy changes, but gold will respond positively to them.

Buy The Rumour, Sell The Fact

Last year the December FOMC marked the low point for gold prices. It was a classic case of where “buying the rumour and selling the fact” was the optimal trading strategy. We cannot help but feel this will be the case again. Every time the Fed hikes, the hurdle for the next hike is higher. The level of economic strength required for the first hike is minimal compared to what the Fed will need to see for the third and fourth hikes.

In our view gold is sitting on a key support zone around $1175-$1150 and from this base it is primed for a $150-$200 rally over the coming month or two. To see what trades we are placing to take advantage of this move please subscribe via either of the buttons below.

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Monday
Nov142016

Gold Prices Have Overreacted To The US Election

To say it has been a turbulent week in markets would be a dramatic understatement. The moves around the US election were nothing short of incredible. We wrote last week about fading a risk off move over the election, and whilst we expected market nerves to calm after an initial period of uncertainty, we were completely blindsided by the pace and magnitude of the reversal. Nowhere are we more surprised than in the yellow metal’s reaction to the result. Not only do we view it as an overreaction, but actually view the gold prices as significantly undervalued in the current environment.

Inflationary Fiscal Policy

The market appears to have taken the view that a Trump presidency will be inflationary. Bonds have been sold, interest rates have risen, and the market has stepped up its expectations of Fed tightening. Given a December hike as a given, then market now has over 100bp of hikes priced in over 2017-2019.

It is important not to confuse this inflationary reaction as “risk on”. Although the S&P 500 has rallied, this is again a symptom of the inflationary reaction. Emerging markets have been crushed.

We are cautious about the reaction. Whilst aggressive US fiscal policy can be inflationary, the effects of such policies take time to feed through. Of course such policy still has to be proposed, agreed upon, and implemented.

When the Hoover Dam project was announced during The Great Depression, thousands of unemployed Americans flocked to Nevada looking for work, shovels at the ready. They were bitterly disappointed when they learned that it would be years before any labour was required, since the dam still needed to be designed, construction planned, and materials sourced.

The story that inflation is coming has been repeated numerous times since the Global Financial Crisis, yet it has yet to really make an entrance. Treat rhetoric along the lines of “this time it’s different” with a large grain of salt.

Gold Drops Back To Support Zone

We saw a big drop in the yellow metal this week as it fell right back to the $1225 support zone. This was in line with the fall in bond prices and USD strength, with the move turbo charged by the realisation that a Fed hike is now just a month away and 85% priced in.

Despite the price action, we find ourselves turning increasingly bullish on gold prices. When we consider the macro economic factors at play and how they have changed over the week, we struggle to come to any other conclusion than that gold could go through a major rally over the next year.

Consider Foreign Policy, Not Just Fiscal

 We have mentioned the potential for US fiscal policy to be inflationary, but haven’t touched on foreign policy. There are two major changes to note there. Firstly the geo-political risk premium should increase given the change in government and its more aggressive stance on numerous issues in the Middle East.

Secondly the change in government is likely to result in more protectionist policies, tariffs, import duties and similar measures to protect domestic industries against foreign competition with the aim of increasing domestic growth and employment. This is undoubtedly a policy path that leads to USD weakness in our view.

FOMC Will Maintain Cautious Stance

 The Fed is going to struggle to deliver what the market now expects in terms of tightening. We are nearly seven years into the economic recovery and we are only just approaching the second hike. Yet the market expects another three hikes over the next two years.

Yellen has said that the Fed would be happy to see inflation overshoot their targets, rather than tighten prematurely. Not only will the inflationary impacts of US fiscal policy take time to be reflected in the data that the Fed has made monetary policy dependent on, but the Fed would be content to see inflation tick higher without tightening, to ensure the economy is running hot enough to take some cooling from higher rates. Of course, this all presumes that such projects do go ahead, and quickly.

Mispriced Risks Creates Opportunities

 Bringing this back to gold, given the balance of risks and the current level of gold prices, we see an asymmetric risk of a major rally. The market is counting on a Republican government to rapidly put into place aggressive fiscal spending, which will flow through to inflation and lead the Fed to aggressively hike, seeing gold prices fall $75 this week.

However we believe the market is nearly fully discounting the following risks;

 

  • Government spending is delayed or doesn’t come at all
  • Said spending does not lead to inflation due to slack in the US economy
  • The Fed lets inflation run higher without hiking aggressively
  • Protectionist policies see the USD weaken
  • Increased geo-political uncertainty in the Middle East
  • Large systemic risks from Brexit
  • US economic data turns after seven years of improvement

 

Risk-Reward Dynamics In Favour Of Gold

Therefore when we look at the risk-reward dynamics in long term options on gold they are very compelling. We will likely begin to execute some of these strategies in the coming weeks and layer into a significant medium term long position in gold.

The next $25 or $50 move in gold prices could be either way given the current volatility. However the next $250 move is far more likely to be higher than lower in our view. Therefore we intend to position accordingly and use options to tailor our trades to fit our view, whilst optimising risk-reward dynamics.

Since our inception in mid-2009, SK Options Trading we were bullish on long and aggressively so until the end of 2012. We turned aggressively bearish the yellow metal at the start of 2013 until the start of this year, when we went more neutral. It’s now time for us to put the bull horns back on.

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