Saturday, August 28, 2010

Proposing an Overnight Gold Fund

There is much debate within the precious metals industry regarding the alleged suppression, or at least manipulation to an extent, by either central banks or the proprietary trading divisions of large banks, or a combination of the two.

In April the US Commodity Futures Trading Commission CFTC fined Hedge Fund Moore Capital for manipulation of the New York platinum and palladium futures market, as the firm was found to be “banging the close”, which involves entering orders in a manner designed to inflate the closing price, which other various derivatives contracts could be based on. So that is irrefutable evidence that the precious metals futures market is, at least to some extent, being manipulated. However a large concentration of this debate is based not on platinum and palladium, but on gold and silver, and particularly gold.

Numerous hypothesises have been put forward as to the motive behind alleged suppression of the gold, ranging from a central bank conspiracy to keep gold prices low, to large trading banks simply exploiting their market dominance for easy profits, or even a combination of the two with the central banks and large bullion trading operations working together in some kind for cartel to keep gold prices low.

This article does not intend to discuss the merits of these theories, however plausible or implausible various parties believe them to be. Instead we will focus on finding out if a discrepancy exists and if it does, can one take advantage of it and use it for profitable trading strategies.

Firstly we would like to recommend an excellent article by Adrian Douglas, editor of Market Force Analysis and a GATA board member entitled “Gold Market is not “Fixed”, it’s Rigged” which goes into great detail on the statistics behind the difference between how gold trades between the AM and PM fix, and how it trades from the PM to AM fix. The very fact that there appears to be a significance difference sets our alarm bells ringing. Whether gold trades in New York, London, Tokyo or Timbuktu, gold is still gold and so one would expect that it would trade in a similar fashion across these timeframes over a long period of time.

If we take the change in the gold price from the AM to PM fix (intraday gold) compare it to the change in the gold price from the PM to AM fix (overnight gold), we can see the startling difference between the two periods of trading.

We will demonstrate this by showing what would have happened if one had theoretically invested in the intraday gold market from 2001 to present. Starting in 2001 with an indexed based at 100, the chart below shows what would have happened to that investment of 100 if it had been used to purchase gold at the AM fix and sell gold at the PM fix, replicating the daily percentage performance of gold in the intraday market.

As the chart above shows, the performance is dismal. For example a hypothetical gold investment fund starting with $100m in 2001, and using it to buy gold at the AM fix and sell it at the PM fix would now be left with just $40million, a 60% loss in just under ten years. Over the same time period gold prices have risen over 350%.

From this we can infer that in fact it was possible to make money shorting gold everyday for the last decade. If a hedge fund were to have sold gold at the AM fix and covered that short position at the PM fix, for each day of this terrific bull market run in gold, that fund would have doubled their starting capital.

This appears to be a remarkable result, as one would presume that shorting gold everyday during a period where the yellow metal has risen 350% would have devastated any portfolio, not caused a 107.5% increase.

Those who do not believe in theories of gold price suppression, often cite the fact that gold prices are at an all time high as a major piece of evidence to discredit any suggestions of price suppression. After all how can the price be being suppressed if prices are sky rocketing?

Well the answer to that question is that if the gold traders at the large banks accused of such manipulation are just trading during the intraday market between the AM to PM fix, they are not too concerned about how gold trades overnight (provided they are not holding positions overnight of course). What matters is how gold trades during this intraday period, and if more often than not gold is falling during this time, and more often than not the banks are short gold during this period, then they are making money regardless of the overnight price action.

It would appear that subtle manipulation is more likely that blatant price suppression.

So the question on the mind of many gold bulls might be; how do I remove this downward manipulation during the intraday period? Even if I do not believe in manipulation, suppression or any other conspiracy theories, how do I eliminate this statistical fact that gold is underperforming during the intraday period?
The answer is to buy gold at the PM fix and sell it the following day at the AM fix, or more simply put, just be long gold overnight.

The graph above shows how rewarding this strategy would have been, with a return of 947% in less than ten years, a return 2.7 times greater than the 350% that would have been made simply buying gold in 2001 holding until now.

With many investors and traders looking for the best way to lever their gold returns, from pouring over drill results to identify the best gold stocks to experimenting with leveraged gold ETFs and ETNs, a more simple solution could be simply to only have long exposure to gold overnight.

For the more cavalier traders, going long gold overnight and then short gold for the intraday period, makes for an even more profitable strategy.

Consider a hedge fund starting in 2001 with $100m, with the strategy of being long gold from the PM to AM fix, and short gold from the AM to PM fix. That hedge fund would be worth $2.16billion today, before any fees and expenses.

This should be enough to catch any investor’s attention. Even without shorting gold during the intraday period, limiting exposure to gold to just the overnight period enhances returns enough to justify using this as a basis for a trading strategy.

As stated at the beginning of this article, our focus is not what or who is causing this discrepancy nor any potential motives for such a discrepancy, but what action to take in order to profit from it.

In addition to incorporating these patterns into our trading strategy at SK Options Trading, we are also looking into the feasibility of launching some form of fund to take advantage of the opportunities discussed in this article. As part of this feasibility study we are looking to gauge investor interest and so would welcome any comments, suggestions or ideas that people may wish to contribute, simply email skoptionstrading@gmail.com

Stay on your toes volatility will be the order of the day and have a good one.

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