25 April 2013 - An Interesting Observation and a Trade Idea

So what you see here is a chart of a Copper ETF vs. the S&P 500. It is interesting to note that copper, which is generally known for being a economic barometer has recently broken down, even while the S&P has reached new highs. The last time copper was around these prices (might not be exact because this is an ETF rather than spot copper or copper futures), the S&P 500 was sitting at 1064.88, a whopping 30% below current levels.

I'm not really sure what to make of this, apart from the fact that this exemplifies China fears (this would make sense as iron ore too has seen better days). As for trades around this, not too sure right now - perhaps plays on companies who use copper as an input?

As for actionable trade ideas, what I'm liking right now is being short DUST (a 3X daily leveraged inverse gold miners ETF) vs being short the GDX (gold miners ETF). This trade should pay off given the large two-way movements in gold miners we have seen and are seeing which causes massive decay to occur in DUST due to it's daily rebalance. When GDX goes down, DUST increases in size - thus "buying low", and when GDX goes up, DUST decreases in size - thus "selling high". The risk to this trade is that gold miners start trending in one direction, which could cause the DUST leg to either become far too large, or far too small.

Another downside to this trade is borrowing costs which can be up to 10% p.a. on DUST and a few percent on GDX.

This is a long term trade, and requires appropriate position sizing (the DUST leg should be a small percentage of your capital). It should also be rebalanced/closed entirely when large moves occur (though we want this to be very loose, hence the small percentage of your capital).

This is what it looks like when things go bad and big moves occur in short periods of time. You would have made 43% * 3 = 126% on your GDX leg, but would have lost 255% on the DUST leg. Note that only unidirectional moves cause big problems. What we want are big daily moves, but no trend.

In the long run, this trade makes bank. 50% * 3 = 150% profit on the GDX leg, and 109% loss on the DUST leg. Not bad, considering the trade has gone terribly in the last six months.

As I think lower gold prices have already been baked into gold miners, since they had started a rapid decline from November 2012, I would even be tempted to take a small long bias (by shorting more DUST) than I should. In summary, this trade could go very wrong - but the risk/reward is compelling in my opinion. Let's track this.

Assumes a $100,000 account:

Short 1656 GDX @ $30.19 = -$49,995

Short 234 DUST @ 85.47 = -$20,000 (this equates to an exposure of $20,000 * -3 = $60,000 due to the inverse leverage factor)

The difference of roughly $10,000 in net exposure is due to my small long bias.