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Extreme Investor Sentiment Indicates A Tradable Bottom In Gold

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The longer you’ve invested in, or traded financial markets, the more you probably realize just how difficult it is to accurately time financial markets. Pundits and talking heads will tell you it’s impossible. However, after 20 years of trading and investing, including stocks, bonds, currencies, futures, and options, I do believe it’s possible to identify key characteristics that are present at or near every major turning point in virtually every market.

Identifying these characteristics can help you get “close” to a major turning point, but you will never be exact without a little luck. They say getting “close” only counts in horseshoes and hand grenades, but that’s not true. If you can get “close” in timing financial markets it can mean the difference between making an absolute fortune or just earning mediocre returns. But you must exercise patience and always utilize discipline when it comes to money management and positions sizing. You have to take care of risk first and then worry about returns.

A financial market, such as gold, or stocks, or coffee, are inanimate and feel no emotion.  However, the individuals that trade those markets are humans and very emotional by nature.  We feel fear, panic, greed, complacency, and euphoria at varying degrees of magnitude. It’s these emotions that drive financial markets to irrational highs and lows. When you understand the degree to which human emotions play a role in the trends that develop in financial markets, it becomes easier to identify major turning points.

As markets move higher, greed, complacency, and euphoria increase. As they move lower, fear and panic increase. When these emotions reach an extreme, the probability that a major turning point is near at hand increase dramatically. When euphoria and complacency are high, it often indicates a bull market that could be nearing an end with remaining upside potential that is limited and significant downside risk. When fear and panic are high, it often indicates a bear market nearing an exhaustion point where downside risk is limited but upside potential is significant. Having the courage to do the opposite of the “crowd” at major turning points is referred to as being contrarian, and is responsible for some of the greatest stock market fortunes.

The other day I came across this chart on Bloomberg showing the cost of put options on gold is substantially higher than the cost of call options.

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Here’s Bloomberg’s commentary to go with this chart

The options market shows that gold’s post-U.S. election slump, which caught many forecasters by surprise, has further to go. Puts betting on a 10 percent drop in futures prices are near the most expensive in a year relative to calls wagering on a 10 percent gain. “The market is getting bearish on the lows,” said David Govett, head of precious metals trading at Marex Spectron Group Ltd. in London.

The way the author of the Bloomberg article interprets the data is that because bearish bets are reaching an extreme, there must be more downside ahead.

While it is possible the gold market drifts lower from these levels, the way I would interpret the data as a contrarian investors/trader, is that because sentiment toward gold is substantially more bearish than bullish (put option premiums are more expensive as traders rush to buy puts in favor of calls in anticipation of further downside), this extreme reading in sentiment will actually mark a low in gold futures and prices will now head higher.

Notice the other instances where the implied volatility of the put options reached a similar extreme (July, September, and December of 2015), prices actually rallied rather than declined.  Furthermore, to have had multiple extreme readings in the implied volatility of the put option premiums in a relatively short time frame, indicated that a much larger bounce was coming in the price of gold. That’s exactly what happened as gold rose from a low of $1,045/oz. in December to a high of $1,377/oz. in July.

In my 20 plus years studying and analyzing financial markets, including analyzing over 100 years of past bull and bear markets, I’ve never seen a major trend reverse without a corresponding extreme in investor sentiment. However, it has happened that I’ve entered  a specific market, after identifying what I believed was an emotional extreme, only to watch that extreme become even more extreme. So please understand, sentiment gages are not a crystal ball, although they can help you get “close” to a major turning point but probably never exact.

One final thought. When you identify what you believe is a major turning point in a particular market such as gold, and rather than trade the futures market (only recommended for very experienced traders) or a gold ETF, you decide to invest in individual gold and silver mining companies, insist on only the highest quality and safest companies. Not only will your capital have greater protection, it can give you greater confidence and peace of mind, so you don’t panic and get shaken out by the volatility that always exists at a major low.

The question you need to answer is “will the company go bankrupt?” If the answer is no, then it is much easier to buy into a falling stock with high probabilities of nice returns as the sector or economy stabilizes.

I believe gold is giving investors and traders who missed the December $1,045 bottom a second chance before prices head much higher.

source: investiv

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