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Michael Fowlkes' Analyst Insights

Options and ETF Analyst Writer
Michael Fowlkes
Author Bio

November 26, 2012 -  Where is Gold Headed?

During the middle of last year, the big talk on Wall Street was gold. Gold was making big gains, leaving everyone to ask if we would finally see the precious metal cross through the psychologically important $2,000 an ounce mark.

It got close, trading to an all time high of $1,921, but it was never quite able to hit the $2K mark. The big reason for the impressive action we saw in gold last year was the crisis in Europe, and those fears have not subsided much over the past year.

Despite the ongoing crisis in Europe, gold has not managed to maintain last year?s momentum, mainly because of the strength we have been seeing in the U.S. dollar.

The topic on everyone?s minds today is the ?fiscal cliff? that the U.S. is facing. Simply speaking? the fiscal cliff is a combination of federal spending cuts and tax hikes. While on the surface, these two things working together sounds good for the economy, they will most likely have the reverse effect.

If the Congress is not able to work to avoid the fiscal cliff, we will see the deficit, as a percentage of GDP, cut roughly in half. This is the plus side, and one that would be good for the economy. On the other hand, the Congressional Budget Office has predicted that the policies would cut GDP by four percentage points next year? sending the nation into another recession.

With so much attention being placed on the ?fiscal cliff?, we expect to see Congress reach some sort of agreement, although this is not something to take for granted. Congress has been pretty polarized in recent years, and there is little reason to believe that will not be the case going forward.

We do expect to see some of deal reached, but even if we do, that will not change the situation in Europe. The European crisis continues to weigh on the global economy, and will most likely result in a wave of new stimulus packages set in place by central banks and governments around the world.

The result of these stimulus packages will be a massive amount of new paper currency entering into economies, which will almost certainly give gold the fuel it needs to head higher.

In a perfect world, Congress will reach deals to avoid the fiscal cliff, while Europe gets its act together. If both of these were to occur, gold prices would head lower, possibly down the $1,000 mark, but the chances of this occurring are almost non-existent.

What we expect to ultimately see is a partial deal on the fiscal cliff, with the European crisis continuing to persist, leading to stimulus plans in a wide range of countries around the globe.

This currency devaluing, and overall fear of the unknown will push investors into gold.

In addition to the European crisis and the looming fiscal cliff that the U.S. is facing, we are also seeing increased tension in the Middle East, which poses a risk to the stability of every economy around the world.

Tensions have always been high in the region, but recent weeks have seen violence increase between Israel and the militant Hamas group in Gaza. Realizing the potential effect this conflict can have on the region and world as a whole, Egypt and other international mediators are working hard to secure a truce, but even if one is reached it would most likely only be a temporary fix on this long-running feud.

If we see violence continue to increase, investors will start to look for any safe haven to protect their savings and gold is the most logical solution. When combined with the situation in the U.S. and Europe, the Middle East conflict is creating a perfect storm for gold investors.

Will the precious metal hit new highs and break through the $2,000 mark next year? That remains to be seen, but the likelihood of $2,000 gold is much greater than $1,000.

If you want to play gold, but are a bit cautious due to the number of uncertainties that surround gold prices, you may want to jump into a hedged position on GLD, the largest ETF tracks the actual price of gold.

To get into gold at the current time, I would suggest using GLD, but would set up a hedged trade on the ETF just in case things turn around quickly and we see gold trend lower.

GLD is up 9.1% so far this year. A nice hedged trade on GLD would be the February 145/150 bull-put credit spread. In this trade, you would sell the February 150 put while buying the same number of February 145 puts for a credit of 40 cents per share. This trade has a target return of 8%, which is 38% on an annualized basis (for comparison purposes only). With GLD currently trading at $165.88, this trade has 9.5% downside protection.

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