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Morning Update

The story of the day is the crash in gold prices which are down about 10% right now following Friday’s 4% plunge. Gold continues to rip through levels of support like they are non-existent, suggesting investors are running for the exits no matter what the price. The sell-off in gold has dragged the gold miners down with it, including Freeport McMoran. This stock is down 12.5% from last week’s high and down nearly 7% today. But option traders are continuing to make bearish bets on the stock which suggests that the bottom may not be in yet for gold or the gold miners.

One of the biggest trades today in FCX was the purchase of 3215 August 21 puts and the sale of 3125 August 27 calls for a net credit of $3.82. This position is known as a risk reversal and is very similar to a short stock position. Typically these option spreads are done against a long term, buy and hold stock position to flatten exposure without creating a tax event. This spread, when done against stock, will cap losses below 21 but also cap gains in the stock above 27 between now and August.

Therefore, this trader must believe that the next four months could be rough for gold and the gold miners. We would tend to agree with this thesis and are reducing our risk and exposure to precious metals and commodities as a result. What we believe we are seeing is traders using the Cyprus situation and poor data out of China to take profits in gold positions they have had for years. Many initially bought gold as an inflation hedge when Quantitative Easing started. But now that we are beginning to discuss the end of QE and there is still no inflation, traders are either taking off their inflationary positions or even putting on deflationary trades. Additionally, the prospect of higher interest rates in the future has investors reevaluating if they would rather own gold, which pays no interest and costs money to store, or US equities, which pay dividends and have been appreciating in value.

We continue to want to own gold, but are capping our risk so that we do not join the panic selling we are seeing. We expect the next few days to be especially volatility and whippy in the gold markets and covering risk keeps you unemotional during these times.

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