Risk Surrounds Gold and the SP 500

By JW Jones - Options Trading Signals.com

The current trading environment is one of the most difficult that I can recall in recent memory. Risks abroad regarding the European sovereign debt crisis is keeping market participants on edge as headline risk seemingly surrounds traders at every turn.

In addition to the risk posed by Europe, the market’s reaction to the Congressional Super Committee’s upcoming statements also poses risks. As it stands now, the media is reporting that the committee is in gridlock and has yet to compromise. The deadline for the Super Committee is Wednesday, November 23^rd. The gridlock leads to uncertainty, and Mr. Market hates uncertainty. High levels of uncertainty corresponds with increased volatility levels, thus caution is warranted.

Recently I have been actively trading around the wild price action, but I have been utilizing smaller position sizes in light of the elevated volatility levels. In addition to the smaller position sizes, I have been aggressively taking profits and moving stops in order to protect trading capital.

This past week, members of my service enjoyed two winning trades. We were able to lock in gains on a SPY Put Calendar Spread for a nice 20% gross gain. On Friday we closed a USO Put Calendar Spread for a gross gain of 17%. These trades were relatively short term in duration, but the gains they produced were strong.

Both trades took advantage of increased volatility which resulted in enhanced profits. If volatility remains elevated going forward which I expect, these types of trades will offer great risk / reward going forward. Volatility is an option traders friend, and this past week members of my service were able to lock in some strong gains with relatively muted levels of risk.

Gold Futures

I have not written much about gold recently as I have honestly not seen a great deal of opportunity in either direction there. The price action has been quite volatile, but this past week we saw gold futures sell off sharply. I believe the explanation for the selloff is partially due to strength in the U.S. Dollar. The daily chart of the U.S. Dollar Index is shown below:

The recent selloff in gold can likely be attached to the increase in margin calls around the world as a likely consequence of the MF Global bankruptcy. Uncertainty surrounds the commodities market as the collapse of MF Global has interrupted traditional capital flows and broad based volume around the world. The MF Global situation continues to provide a negative headwind for financial markets in general.

I continue to be a long term bull regarding precious metals as nearly every central bank is either printing money deliberately or is increasing the money supply through quantitative easing. With multiple calls coming out of Europe over the weekend for the European Central Bank to print money to monetize European sovereign debt, it may not be long before the ECB begins their own quantitative easing program. In the long term this can only mean higher prices for gold.

Right now the short term looks bearish for gold as the daily chart of gold futures shows gold tested near the top of a recent rising channel and failed. The selloff was strong, but  a pullback here makes sense from a technical perspective. The daily chart of gold is shown below:

The longer term time frame continues to remain technically positive for the yellow metal. As long as gold prices hold in their multi-year rising channel, higher prices remain likely. Right now the $1,500/ounce price level needs to hold as support if the bulls are going to remain in control in the long term time frame. The weekly chart of gold futures shown below illustrates the long term rising channel:

Right now we are in a seasonally strong period for gold. I am going to be watching closely in coming weeks for a solid entry point to get long the yellow metal for a longer term time frame. Right now the short term remains bearish, but the longer term is bullish from technical and fundamental viewpoints.

S&P 500

The S&P 500 Index sold off sharply during the past week. In my most recent article, I discussed two key price levels to monitor to the downside. The key support levels were the 1,230 and 1,190 price levels respectively. The bulls need the 1,190 area to hold as support to give them any chance for a “Santa Claus Rally” into year end.

Last week the S&P 500 Index closed below the 1,230 support level meaning the 1,190 area has to hold. Otherwise, we could see a sharp selloff into the end of the year. The daily chart of the S&P 500 below illustrates the key support levels:

The S&P 500 looks vulnerable to the downside presently. However, headlines coming out of Europe and/or the Super Committee this week could push prices higher. The key pivot line remains around the 1,257 price level on the daily chart. If the bulls can regain the 1,257 price level on a weekly close a test of 1,290 will become more likely. However, as long as prices remain below 1,230 and 1,257, the S&P 500 is vulnerable to additional downside.

I would not be shocked to see the S&P 500 push higher this week to work off short term oversold conditions. Truncated weeks result in lower than average volume which generally favors the bulls. However, in this environment anything could seemingly happen. Risk is high in either direction.

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Is The SP 500 Putting in a Top?

The past few months have been very difficult to navigate for retail investors and institutional money managers. The huge week to week price swings and increased volatility have made the current market conditions exceptionally difficult to maneuver. Day traders are about the only group of market participants that outperform during periods such as we have seen since the beginning of August.

Before I jump into the analysis, I would like to point out to readers that the S&P 500 Index (SPX) has rallied from 1,075 on October 4^th to 1224.50 on October 14^th. The S&P 500 has rallied almost 150 handles or 14% from the lows to Friday’s close in 10 calendar days. As an options trader and a market participant, I trade the market that I see, not the market that I want. With that said, ask yourself this question: Does a healthy financial construct rally 14% in 10 calendar days?

To put the recent price action into perspective, since the beginning of the year 2000 the S&P 500 would have had a poor track record on an annualized basis when compared to the past 10 calendar days’ trough to peak performance. Only in the years 2003, 2006, 2009, & 2010 would an investor have been able to best the previous 10 calendar days’ performance (Performance data courtesy of Wikipedia). The most amazing thing about the recent price action is that the S&P 500 Index is still underwater for the year even after rallying roughly 14%.

At this point two scenarios are likely to play out. One scenario involves a rally on the S&P 500 towards the key 1,250 – 1,270 resistance zone which is outlined on the chart below. The recent price action in the S&P 500 has been volatile and at this point it has gone nearly parabolic. The daily chart of the S&P 500 Index is shown below:

The resistance level shown in the chart above outlines the key 1,250 – 1,270 resistance zone that will be tested if the S&P 500 can breakout above the 1,230 resistance level. However, it is critical for traders to recognize that probabilities are starting to favor the short side. Let me explain.

If the S&P 500 is able to rally into the 1,250 – 1,270 level it would represent a gain of less than 4%. The bears will vigorously defend the S&P 1,250 – 1,270 resistance zone and it is unlikely that price action will be able to take out that resistance zone on the first breakout attempt.

With only 4% upside, the odds of some sort of correction are favorable at this point in time. Whether the correction begins early next week or whether we have to wait until the key resistance zone is tested, sellers will step back into the driver’s seat in the not so distant future.

McClellan Oscillator

A few data points that exemplify the overbought status of the S&P 500 are shown below. The first indicator is the McClellan Oscillator that my trading buddy Chris Vermeulen pointed out to me.

50 Period Moving Average Momentum Chart

The momentum chart shown below courtesy of www.barchart.com illustrates the number of domestic equities trading above their key 50 period moving averages:

Both charts above are warning signs that this rally is starting to get a bit overheated. I would point out that the past two times the McClellan Oscillator and the momentum chart peaked a nasty selloff occurred shortly thereafter. The one point that I would like to make clear to readers is that each time both indicators peaked prices eventually went much lower.

The evidence would lead astute traders to believe a top was near. The more arduous details about the future of the S&P 500’s price action revolve around where the topping formation will be. Will the S&P 500 find resistance on a second test of the key 1,230 resistance level?

The other scenario would involve higher prices next week that eventually reach the key 1,260 – 1,270 area on the S&P 500. Will price work roughly 4% higher before confirming a top at the key breakdown level that initiated the selloff back in August?

Conclusion

I am of the opinion that a topping formation or pattern is likely near, but the location of the top is unknown to me presently. More importantly the forthcoming selloff resolution will be very telling about the current trend of the marketplace.

The most constructive price action that we could see would be a selloff that results in a higher low on the daily chart. If that type of price action plays out a new bullish run could begin. However, if we form a top and price action breaks down below recent lows it would not be surprising to see another lower low form which would put the trend squarely in favor of the bears.

The most important aspect of coming weeks will not necessarily be where a top forms, but if and when a selloff begins. Ultimately the depth, momentum, and ferocity of the selloff are more important than where the topping pattern begins.

At this point I have no purely directional trades on the books, but I am developing a laundry list of shorts that make sense. After all, volatility has declined quite a bit and puts are starting to get a whole lot cheaper!

In closing, a top is likely in the cards in the near future. However, the strength and momentum of the forthcoming selloff will tell the real story about the future direction of stock prices. The next few weeks should be quite interesting!

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JW Jones

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