We preface this article by stating that we are neither gold bears nor bulls. We are traders and we target trades with the best possible risk/reward dynamics, regardless of market direction. At the founding of our service, SK OptionTrader, we were bullish on the yellow metal and banked considerable profits as gold rallied to all-time highs. Beginning in 2013 we took a heavily bearish view, and again banked triple digit returns on gold as it declined. Now, we believe we have seen the lows and are preparing to get long gold once again.

Fear around the effects of China’s currency devaluation has led to turmoil in financial markets. Equities have sold off, bonds have rallied, and volatility has spiked. The medium term future of US monetary policy has been thrust into darkness as concerns around the economic outlook have risen rapidly.

As a result of the change in market dynamics we believe that gold has the potential for a sizable rallyfrom here and that there is the potential for gold to challenge both the medium and long term downtrend lines. This means that the medium term lows around $1050 are highly unlikely to be visited in the coming months and we intend to take full advantage of that.

Gold has failed to rally on key bearish events

Gold and US real rates have long held an inverse correlation. When rates were cut and the Fed embarked on massive QE, gold rallied to all-time highs. Once the Fed implemented QE3 the economic outlook improved. This meant that more QE would be unnecessary and that the current measures would be tapered off. While this took place gold fell back from its all-time highs, entering a bear market in April 2013.

In December 2015 the Fed raised interest rates for the first time since 2006. This began a new tightening cycle and was accompanied with overall hawkish sentiment and dot projections that indicated the Fed expected another 100 basis points of hikes would be required in 2016.

This was the most hawkish monetary policy since action taken in nearly a decade and should have been heavily bearish for gold. However, the yellow metal failed to break through support at $1050 and did not even challenge the longer term support level of $1030.

At the beginning of this month the employment report showed that nonfarm payrolls had increased by a considerable 292,000 and that previous two prints were revised upwards by 50,000 new jobs. This is the type of improvement in economic data that the Fed would use as good reason to hike rates again. Therefore the print should have sent gold lower, as it made further hawkish action more likely. Yet, gold maintained its strength on the print and has failed to break support at $1080 in the week since.

What will drive gold down?

If gold cannot break to new lows on a hiking cycle and continued economic strength, then what will drive the metal lower?

Fresh ECB QE is likely to be bearish for gold for the same reasons that QE3 in the US was. However, the ECB is unlikely to announce new measures at their meeting this week. This means that the earliest likely target is their March meeting. Therefore before March 10^th there is unlikely to be a major catalyst to drive gold down outside the US.

The next Fed hike has the potential to push gold lower, as it will drive home the point that rates are rising and that we are now in a tightening cycle. This means we must ask, when will the Fed next hike?

Given the current financial turmoil on the back of China’s currency devaluation, it is near certain that the Fed will not use their January meeting to raise rates again. The mayhem also means that March, which we had previously believed to be highly likely to hold the next hike, is much more uncertain with market pricing now shows the chance of a March hike to be just under 30%.

It is highly unlikely that shocks that cause other markets, such as stocks, to fall would cause gold to fall also. Gold is a safe haven asset, and therefore unforeseen events are much more likely to drive the metal higher than lower. Therefore, our bearish factors are limited to monetary policy. Given that major central banks are unlikely to take action that will be bearish for gold, there is no significant catalyst to drive gold lower this month, the next, and at least the opening weeks of March.

Does this mean gold is going higher?

Just as the lack of a bullish catalyst will not cause gold to fall, the lack of a bearish catalyst does not necessarily mean that gold will rally. However, in this case we believe that there are a number of reasons that lead us to the view that gold prices are heading higher.

Firstly, there is the discrepancy between bond prices and the price of gold. Bond prices have risen as the chances of a Fed hike in the next three months have decreased. Gold followed bonds higher initially, as per their long term relationship, but the metal has failed to continue the upward movement.

As a result, the current bond market indicates that gold is in fact heavily underpriced and should be much higher. Based on the last close for SHY, an ETF tracking 1-3 year Treasury Bonds, gold should currently be trading above resistance at $1150. However, Friday’s close puts gold at $1088.60.

This discrepancy is too large to be just noise. Therefore either gold prices must rally or bonds fall. For bonds to fall there would have to be an increase in the expected probability of the first hike coming sooner. This is means that concerns around China’s currency devaluation would have to dissipate, markets would have to calm and equities begin to recover. For this to all take place before the March FOMC meeting is highly unlikely.

A much more likely scenario is that concerns will persist for some time, and that markets will recover more slowly. This means that bond prices are much more likely to rally than fall from here. This in turn means that gold is likely to rally more than the $60 it is already under-priced by.

Therefore, the next $100 move in gold is higher, not lower, and is likely to take place inside the next two months. This means that the medium term lows are in and that it is time to get long gold, or at least cut any short exposure.

What is the trade?

There are a number of ways to access movement in gold. One could buy GLD, the ETF that tracks gold, but this is not the vehicle lacks any leverage to the metal. One could by gold stocks, but given the market dynamics there is a strong argument against this.

Suppose that one held the view that gold was going to rally due to continued financial market mayhem, as we have covered above. Then surely they must also hold the view that equities will continue to fall. It is much more likely that gold mining stocks will be sold off as a stock than bought into a rally as a gold vehicle. This means that overall gold stocks are a poor investment in the current market conditions and far from the best way to access the coming rally in gold.

We believe the best way to gain leveraged exposure to this rally in the yellow metal is through options. A fine-tuned options strategy here can be geared to take advantage of the exact market situation and gain significant leverage to gold while keep risk limited.

A strategy that stands out for us immediately is selling vertical put spreads on GLD. Our analysis shows that a bearish catalyst for gold is unlikely to be in play until March, so we will look to options with March expiries. We will now consider such a trade with strikes around $100, which corresponds to $1050.

If gold falls less than $40 between now and March when these options expire, then the trade will make its maximum profit. While this is not a heavily bullish trade and the upside is not astronomical, the trade still has very positive risk reward dynamics. Even if market conditions change rapidly and begin to recover, this trade is still likely to bank its maximum return.

We are also considering much more bullish plays if market dynamics continue to become more bullish for the metal. Should gold break through the long term downtrend line, currently just below $1200, then we will look to take advantage of the new bullish trend by opening much more aggressive positions.