A trade on the much awaited NFP number

The US is due to report its Non-Farm Payrolls number for the month of August come Friday at 8:30AM Eastern Time (8:30PM Local Time). Estimates call for 180k jobs to be created in the month of August.

In the aftermath of Jackson Hole last Friday, it appears that this upcoming Non-Farm Payrolls (NFP) number is going to be a crucial factor in deciding the odds for a rate hike in September. I believe the market is going to be watching this number extremely closely, as well as the unemployment rate and other employment metrics like average hourly earnings, to be released concurrently. I expect the subsequent reaction to be raucous, whichever way the market swings. This would be most prominently reflected in two assets: the USD and Gold.

The past 2 months, namely June and July, have seen solid NFP numbers that beat expectations. I believe the market is expecting a third month of solid results.

Taking a closer look at Gold (Ticker: XAU/USD) on the daily chart, the market is beginning to look short-term oversold, with the Stochastics Oscillator under the 20 mark. Prices are hugging the lower Bollinger Band, remaining below the 20-day SMA. XAU/USD is also lingering near the 50% Fibonacci retracement level at 1308, acting as short term support. The round number 1300 also acts as a psychological support level.

With gold at seemingly oversold levels, a strong and sharp move (eg. Selloff on high volume) is required to push prices further down. This could be precipitated by:

1. A very strong NFP number - this would indicate the labour market is strengthening sufficiently to withstand a rate hike as early as September.

2. NFP narrowly beating/matching expectations and other employment metrics coming within market expectations.

3. Sudden consensus among traders that the US economy would be able to withstand a rate hike come September, no matter what the data. (Unlikely to happen)

In either case, it would send the USD soaring. Gold, an asset which yields nothing, would underperform in times of rising interest rates and therefore would experience a selloff. With the USD strengthening and Gold weakening, XAU/USD would fall.

However, given moderately oversold conditions in Gold and expectations for NFP results justifying a September hike, I believe the big downward move in gold over the past few days has already priced in quite a lot of those expectations. At these levels, it's also hard to justify taking up short positions in Gold, for lack of a clear risk-reward profile.

Even if the NFP number came in solid, I'm doubtful that any sharp downward move would be sustained for very long, for the following reasons:

1. A lot of traders are already riding on long dollar (and therefore short gold) positions - A move downward would spur profit taking, which could swing gold in the opposite direction equally quickly. In fact, the opposite reaction could very well happen, as has been observed so many times in the forex market (eg. RBA rate cut), when so many traders are on the same side of the market.

2. Gold's long term appeal has not diminished - With more than $10 trillion of negative yielding sovereign debt worldwide, and so many central banks planning rate cuts or adopting negative interest rate policies, gold has attracted plenty of investor dollars this year. Those who have missed out on its meteoric rise so far could see this short term dip as a chance to join in the party, therefore lending support to prices.

I'm inclined to think that the market has become very one sided now. With so many traders long the USD, the probability of a disappointing NFP figure has been deeply discounted by the market. Sure enough, the ADP Non-Farm Payrolls, data complied by a private firm, may have narrowly beat expectations (177k vs 175k), but the actual NFP reading has been known to differ widely, or could miss expectations altogether (eg. the May 2016 NFP number). The market has not sufficiently considered such a possibility.

Therefore, what I am playing at is the possibility that the data this Friday disappoints. Any bad data that could suddenly take a September hike off the table has not been priced in and therefore for now, I believe, the potential upside in Gold is much greater than the potential downside. Gold has the potential to rally, perhaps back into the 1350 zone, should the data disappoint the hawks. A round of short covering could quickly ensue, lending support to higher prices.

However, one can never be certain about the outcome of such events and therefore much caution is necessary. Instead of directly taking a long position in XAU/USD, I've opted to go for the Gold Miners ETF (Ticker: GDX) instead, which is a good proxy for Gold itself, as well as having a beta >1 relative to Gold. But since a big move in GDX could also be expected, I would not want to be outright long GDX as losses can be very costly should it fall (or even worse, gap down) a few percent.

Instead, I opt to play GDX via options, where my maximum loss and profit can be defined from the onset of the trade. That's the beauty of options.

Implied volatility of at-the-money call and put options for GDX expiring 2 Sept is around 66%, translating into an expected standard deviation of about $1.54 from now until expiry. Simply put, there is a 68% chance GDX is anywhere between $24.15 and $27.20 by Friday.

The Trade:
This is a options play and therefore a high-risk, high-reward trade. Obviously, I do not have sufficient funds to execute this sort of trade with real money and hence this shall be a simulated trade, as a test of my judgement and part of my learning process.

Long 1x GDX 26.5 Call expiring 9 Sept @ 0.39
Short 1x GDX 27.5 Call expiring 9 Sept @ 0.15
Net cost of trade: $24 (assume no commissions)

Strategy employed: Long Call Spread

If held to expiry:
Maximum potential profit = $100
Maximum potential loss = $24

Profit Target: A daily close for GDX above $28 before the Wednesday following NFP and I'm out.

Stop Loss:
1. Close position if a big move fails to materialise after NFP
2. Will close position by the close of trading on Wednesday following NFP as a time stop, salvaging whatever remaining time value left in the options.
3. XAU/USD falls after NFP and so does GDX

Note:
At nearly 4:1 odds I believe this is a good trade to express my bullishness in Gold. However, time decay will act savagely against me, with so little time left to expiry.

A rapid move upwards is needed to generate any profits. Therefore if I were trading this position for real I'll probably go small to minimise potential losses should it turn sour.

Even if I'm dead wrong, the most I stand to lose is $24 per call spread bought. If I'm right, I stand to make several times my money. Fair enough.

Just my two cents.