The price of gold has been trounced the past few weeks, and most of the bulls have left the building. The price of gold has slid $175 since election night, but this pales in comparison to the amount of bulls heading for the exits. According to the Daily Sentiment Index, bullish sentiment on gold has dropped from 49% bulls one month ago, to 6% as of Friday’s close. What’s even more significant is that sentiment has only been this pessimistic one other time in the past 30 years. This occurred between September 8th 2014, and October 6th, 2014, and returns were strong following the signal. While this did not mark the absolute bottom for gold, it did provide a 10-day return of 6%, and a 3-month return of nearly 9%.
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We are currently tied for the 30-year record for bullish sentiment under 15%, and a close under 15% bulls Monday will mark a new record. In my opinion, this is a very strong contrarian buy signal for gold investors. Out of nearly 6000 trading days the past 30 years, this is the most pessimistic futures traders have ever been on the metal. The 21-day moving average for bullish sentiment on gold was 9.8% during the previous record, and currently we have a 21-day moving average reading 9.76% on bullish sentiment. This means essentially that are more than 9 bears to every bull over the past 21 days for gold.
So what is the best way to play this potentially unprecedented signal? Here are two ways to play the extreme pessimism in the gold market:
1) Go long gold at current oversold levels with a stop on this trade at $1,130 / oz. As we can see from the below chart of gold with the MACD included, the metal is extremely oversold at current levels. While this does not mean the bottom is in, similar readings over the past year have marked bottoms for the metal. You can go long bullion, purchase a gold ETF or build a portfolio of quality mining stocks. Click here to view the Gold Stock Bull portfolio in real time.
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2) Open a short position against DGLD, a 3x Inverse Gold ETF. By shorting a triple inverse ETF, you are assuming a positive position on gold (or going long).
Inverse ETF’s decay over time due to different hidden fees, one of which is management fees. I have done different studies on DGLD, and it is the safest way to be long gold in my opinion. Based on the past 3 years for DGLD, the average annualized decay on the ETF is 10.04%. This means that assuming the price of return of gold returns 0.00% over a given year, the ETF would fall by 10.04%. By shorting DGLD, investors can make a lot of money if gold goes higher, but are protected on the downside if gold does go down. Investors will need a margin account to participate in this trade, as shorting is not allowed in most regular investment accounts.
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As we can see from the above spreadsheet, gold has dropped over 6% between the second week of December, 2013 to the first week of December, 2016. The implied return on a 3x ETF that is short gold would be 18.42%. Instead of seeing a positive return of over 18%, the ETF has lost over 18% over the same time period. This means that the return of the ETF has a difference of 36.49% from its implied return to its actual return.
Since the second week of December, 2014, and the second week of December, 2016, the price of gold has dropped from $1,222 / oz to $1,162 / oz. Given that DGLD is a 3x inverse ETF, one would expect to have seen a positive return on their DGLD position. Due to the decay in the ETF, those who went long DGLD in December would instead be sitting on a 10% loss. This is extremely frustrating for investors who do not understand how these instruments work. Despite being able to correctly predict that gold would be lower, they are actually down on their position. The implied return over the past 2 years is 14.79% for investors, but instead investors are down 9.78%.
Shorting 3x inverse ETF’s is a very dangerous game if you are not willing to hold the position long enough to let the decay exploit itself. My DGLD position will be held for a minimum of 4 years and up to 7 years. Given the 10.04% average annualized decay on DGLD, this means that DGLD should see a 40% plus decay by December of 2020. What this means is that as long as the price of gold is above $1,005 / oz by December 2020, the trade will be profitable. The longer I choose to hold my position, the less risk I have on the position. Over a 7 year time period, the position will decay by nearly 71%. In order for the ETF to stay at the same price as today, the price of gold would have to drop by at least 23.4% (71