c




 c

   
 
 

We read an interesting sales pitch on the Street.com Friday. Here is an excerpt:

¦
 
 

 
  
 
 !"#   
 


$
%! %&"!
"'

To restate:
͞Buy Gold. Buy it in a less liquid, wider bid/ask market contract than April GC or
GLD and buy it through and/or from us. Buy a contract whose liquidity will also
most likely not be there when you need it most whether you are profitable or
losing money.͟

Forget the bank͛s opinion. We ourselves are bullish. But it is commonly agreed among paranoid
yet savvy traders that if Goldman is recommending you to buy, it is because they are already
long and are maybe looking for an exit strategy for themselves or a client they favor.

No doubt, sometimes you make money getting long when GS says ͞Buy͟. And that is because
GS has uncovered a soft spot and the market will overshoot even their inventory overhang
being liquidated. Or because their own client told them to buy. Or perhaps you were an early
entrant in their ͞find the bigger fool͟ race. But sometimes you don͛t make money.

Here is what we want to focus on: The recommendation of buying a deferred expiration future
when so many more logical choices are available. Warning: lots of derivative talk ahead. We
were on a caffeinated roll when we wrote this and didn͛t make the time to translate to normal
English.
rhy the recommendation is Bad or at least not optimal for most people.

The real poker-tell here for us is how the bank is recommending you to get long.
͙͞get long on gold by buying the December 2011 futures contract͙͟

Right off the bat the math is wrong. Using the warped logic that recommends buying deferred
expiration futures: A three month target of $1480 translates to an August future at the latest.
Why would you tell someone to pay more carry cost than necessary? But let͛s look at the
implications of any deferred future recommendation as a market taker (i.e. lifting offer/ hitting
bid client)

Let us now count the ways that this December purchase is both ridiculous, negligent, and
possibly the most obvious tell on earth as to what their position actually is.

1. $
( 

 
,
currently the April contract. Which means the implicit fee from the bid/ask spread will
be bigger on entry into the long position. Is this added premium worth it? NO. Gold is
Gold, and the difference in price between April futures and December futures is the
opportunity cost of money. Gold today is gold tomorrow plus the cost of how much
interest it would be to borrow money to buy the contract. Note we said continuously
liquid. There are times when December will be almost as liquid as April (with a wider
bid/ask no doubt), but the real hidden hazard is continuity. Translation: ͞When you
NEED to get out, because of the gold market washing out, the stock market washing out,
you kids college tuition due, war, peace, pestilence, or whatever͙..that exit liquidity will
be AWOL relative to the front month͛s liquidity.

2. ü

()Rilver and spreads went backwardated,

guess which contract would benefit? April. Ro as unlikely as it is to happen, buying
December takes the whole homerun from physical delivery issues right off the table. You
are actually short optionality on a short squeeze. Guess who is long it? Rpeaking of
Rilver: how is it that GR didn͛t tell their clients Rilver would go backwardated? It was the
trade of the year and much easier to see than if the market itself would go up or down.
Do you think they missed it? We doubt that. We also doubt they would let you in on it
until the trade was exhausted. We know of two hedge funds that didn͛t miss it, and they
told no one anything on their bet. We found out after the fact. When JPM crushed silver
spreads and carried out a prominent futures local out on a $10MM stretcher, were their
clients in on that one as well? We wonder if GR was caught on the other side of that
disaster. Probably not. They probably benefitted. But by all means buy gold because
they think it͛s going up. Enjoy the crumbs from a TBTF bank͛s best trades. It will also
come with one of those neat oval stickers you can put on your Land Rover
 . 

, upon exit especially in a market washout scenario,
Murphy͛s law applies. The marketmaker of last resort will be Goldman. And guess what
he has on his book as your position being, LONG and WRONG. The exit vig will kill you
much more than those low-low commissions promised by your benevolent banker.

A Graphic Interlude: rhat Determines a future contract͛s value

Gold Futures Spread Curve (aka Cost of Carry)

Bond Yield Curve

Source: FMX|Connect
Source: Bloomberg

These charts are on different scales and not perfect renditions. But you see the point. The
difference (for now) in gold future expirations is a function of interest rates, be it treasuries,
LIBOR or some other correlated instrument that measures opportunity cost of carry. Futures are
just synthetic forwards and vice versa. There is no benefit to buying less liquid instrument unless
you are the marketmaker and can make more money in bid/offer fees than you lose in cost of
carry arbitrage. There is a reason these curves are similar. Any variation is arbitrage, though not
without risks. A future contract in Gold͛s value is a mathematical equation.
Rpot price x days to expiration divided by 365 x the risk free rate of money for that time period +
some storage cost factor= the future price.
There are 2 scenarios that will change that math. When a shortage of physical gold reflects a
need to roll futures to spot (unlikely but we can pray!) or when aliens land that eat Dec gold and
crap April gold (Moonshot contango)
Also, buying a December future contract does not limit your downside risk NOW as many people
think. ͞It͛s Gold in December, not now right?͟ There is another word for that. It is called a
DECEMBER CALL OPTION.

rhy the Banks may be legitimately recommending this tactic and why that
recommendation assumes you are too stupid to understand the risks of getting long another
way:
͞You may be holding it for a long time and we are trying to save you the rollover cost
execution.͟

a. Math is math. Rolling over your long every expiration will cost approximately as
much money as the complete contango from April to December right now. Add in
the ͞We know you͛re a buyer so we͛re gonna back off and raise our Dec. ask price
because you are a captive client͟ and you will most likely get crushed. They can͛t
fade you in April. They have more competitors there.

b. Even if " is wrong and they are not fading you, and the monthly rollover carry is a
tick or 2 more than just buying and holding the December future, we͛d rather pay
that liquidity premium any day instead of being kept on hold while our broker,
banker, AND counterparty susses out our position before making a market in a back
month future. Even if you execute the Dec contract for yourself on a screen, who do
you think is bidding up the December contract with no fear of anyone selling it to
them? They borrow at 0.00% interest. Their staying power is bigger than you and
your 18% visa card. And they know you are coming to buy. Its Bayesian probability
and asymmetric risk for them. You are toast. Their whole commodity model has de-
evolved into a Martingale trade, And Double Zero is the Fed going under.

c. If it were more efficient to buy December futures than to buy April and roll them
over, there would be no back month independent marketmakers or arbitrageurs,
because there wouldn͛t be sufficient edge to support their trading. But yet there are
plenty of back month futures marketmakers willing to make a market in something
you know infinitely less about than they do. Back month marketmaking is not a
public service. Meanwhile, there are hardly any spot month independent
marketmakers anymore, because the market is just too tight to make a living unless
you are arbing another venue. Natural flow as a result of transparency and
technology makes the market now. December, not so much.
rhy they may be recommending this tactic with less than your best interests at
heart:1
1. They could already be long December contracts given to them from producers who
hedged production last year. The Bank͛s own hedges could be in April and they seek
exit liquidity on their December long leg while they unwind their shorter dated leg,
which is infinitely more liquid for them.
2. They are long April and are perfectly happy putting on the April/ Dec spread at
higher than interest rate differentials. Specifically, 8 month rates will be less than
what you pay buying December at a price while April is trading at a lower price.
Example: they sell Dec, buy April and collect a cost of carry spread of say, .25% and
then trade a bond spread that charges them .15%. Tadaaa, inefficient markets make
them money.
. Because their market share in commodities has shrunk since ETF͛s have trumped
their own GSCI for retail flow, and they have to make up some ͞special͟ reason to
buy a December contract in Gold.
4. Maybe they are helping to create exit liquidity for a client they give a shit about,
someone like Paulson? Free Abacus with every Dec future?
5. Some other reason our paranoid minds haven͛t thought of.

In the one size fits all category, they should be telling you to buy an ETF. No rollover risk,
less entry and exit vig and no cost of carry. But they can͛t control that transaction can
they? Unless of course they expect a paper versus physical delivery issue. In which case
you should be long April, not December.

Even if their idea is legitimate and we͛re wrong"

  



    

* 
+ ,"

The irony of a good marketmaker is that his success attracts competitors and his service is then
no longer needed. As these banks make less money on tighter bid/ask spreads they seek
legislative protection of their franchises, less transparency, restrictions on competition and
such. Call it white-collar welfare. Failing that, they seek more and more arcane ways of
convincing you to put on a position which could be executed much less expensively. They seek
to migrate your positions into the desert of liquidity. Where transparent light rarely shines. This
way the bodies are harder to find if it blows up. They are in a war with exchanges as well.
Exchange products are trumping bank intellectual capital and salesmanship. And so the banks
are trying and succeeding in buying pieces of them now. There is a new wall going up, and it is
being constructed by the government around the Exchanges. The banks want to be on the right
side of that wall. Even while they rail against the exchange clearing monopolies, they want in.
But we digress.

1
All hypotheticals, but all reasonable given past performance of all firms with inherent conflicts of interest seeking
to sell their upstream inventory downstream.
re are Bullish on Gold

Here is what we are telling you at the most basic level: if you are bullish, and haven͛t fallen
asleep yet reading this; buy the front month contract and use some reliable methodology to
generate a stop loss. Be it technical analysis, bank roll management, voodoo, interest rates or
whatever. Just have a level to get out if you are wrong.

If you insist on buying a December futures contract, the screen market will be 2 to x as wide as
the April, and we͛re sure higher than the cost of carry. Whatever gets you through the night we
guess. Vaya con dios.

If you wish to express your position in options, consider a tight December call spread or a ratio
if you are not afraid of margin calls. But learn what we are saying here first. Google it or email
us. We͛ll respond.

If you want to get fancy, do what the pros do, a covered write. Buy April Gold. Then ask yourself
at what price do you want to get out? Goldman says $1480.00. If you agree, sell a December
2011 $1500 call and create a dividend for yourself if the market doesn͛t get there. If it does,
laugh to the bank. Just make sure you have the capital to handle a margin call, even as you are
making profits. Keep your powder dry and don͛t put too much in any one idea.

rhat re Do

We don͛t sell securities and we are not a brokerage firm. FMX|Connect is a research and data
firm. We believe broad based ideas on markets are fine. But when you put out one size fits all
recommendations to the public without knowing their risk tolerances, financial goals, and other
exposure to highly correlated markets, you are just chumming for saps to call you with their
money.
We make our money selling research on oil and gold derivatives. We have opinions on the
market and share them from time to time. We put positions on in our personal accounts too.
Just know that when we say we like the market, we didn͛t buy it  months ago. Our opinions
have well defined reasons and entry-exit points. We look for asymmetrical risk reward and
express those in futures and options. We expect to be wrong 50% of the time. But we expect to
make more money when we are right than lose when we are wrong. More importantly, we can
help to express directional opinions in ways that fit an investor͛s risk tolerances. We do not take
the other side of our client͛s trades. There is plenty of liquidity out there for good execution.
It is far too easy to make recommendations in commodities based on opinion without citation.
There is no PE to gold, no hard evidence to support or project future demand. So to say:

! Gold will go up because of continued weakness in the dollar OR

! Gold will go up because of European unrest and a flight to safety OR
! The Chinese demand for gold is skyrocketing

Is all conjecture. They may be right, but we read this crap on twitter all the time. Wrapping it in
a TBTF bank label doesn͛t make it more right. It is just some monolithic bank trying to tap into a
grass roots trend and co-opt it so they can survive and feed the squid money hunger. It is
instinctual for an institution, be it finance, politics or other to want to survive above all else.
What do you expect when personal responsibility has been removed? TBTF indeed.

If you want to invest in gold or any other commodity you need to see the idea in the context of
your own personal financial situation. You also have to know what could go wrong. Seek out
your counterparty͛s opinion on why they are shorting what you are buying, not your soul-
mate͛s.

That type of advice and access to Cameron Hanover Energy Research by Peter Beutel is what
we charge for, like the merchant banks of old. Before they figured out that it was also profitable
to be counterparty and broker to their client because advice just wasn͛t generating enough
Ferrari gas money.

We͛ll never be as profitable or as big as those guys. We don͛t want to. We want to get paid for
helping in the field we know a lot about: Commodity Fundamentals and Derivatives. We are not
trying to make money first like banks, and if in the process of doing that our clients don͛t get
slaughtered͙ well then goody for us. We͛ll leave that to the carpet-baggers. Making money
should not be your business, it should be the by-product of a good business. If you can͛t make
money while doing something helpful, then change careers. And there is room for this type of
thought, even in finance.2

Just think for yourself. Why is a hedge fund manager on the cover of Barron͛s telling you to buy
a stock? Is it because he is an altruistic philanthropist who just wants to give you money, or
rather would a nice media-driven price pop give him an exit liquidity for what is already too big
of a position for his fund to carry?

2
Strains of Jerry Maguire?
Here is how we͛d like to see a recommendation to buy Gold when no details of the tactical
issues are explained in the advertisement͙ errr we mean article.

Gold: Buy it to hedge inflation, deflation, sovereign risk and purchasing power
impotence
Note: may cause nausea, vomiting, sleepless nights worrying if you put too much money into
the trade, margin calls, anxiety at not knowing what it is you actually have in your portfolio, loss
of hair, wealth, being put on hold when you need to get out, higher taxes and general
discomfort. Consult your broker if any of these symptoms persist. He͛ll be able to help by
suggesting a bond short to hedge cost of carry risk.

Actual excerpt from a GS Disclaimer. Emphasis ours.

Conflict of Interest Disclosure: We are a full-service, integrated investment banking,

investment management, and brokerage firm. The professionals who prepared this material are
paid in part based on the profitability of The Goldman Sachs Group, Inc., which includes
earnings from the firm's trading, capital markets, investment banking and other business. They,
along with other salespeople, traders, and other professionals may provide oral or written
market commentary or trading strategies to our clients that reflect opinions that are contrary
to the opinions expressed herein or the opinions expressed in research reports issued by our
Research Departments, and our proprietary trading and investing businesses may make
investment decisions that are inconsistent with the views expressed herein. In addition, the
professionals who prepared this material may also produce material for, and from time to time,
may advise or otherwise be part of our trading desks that trade as principal in the securities
mentioned in this material. This material is therefore not independent from our proprietary
interests, which may conflict with your interests.

Trade or Broker. But don͛t do both

Good Luck and don͛t be stupid.

FMX|Connect
Commodity Information Portal