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Yellen has Lift Off, But Rates Won’t Go To The Moon

At the FOMC meeting last week the Fed raised interest rates for the first time since 2006. This was a historic moment marks the first rate hike after the Fed engaged in massive quantitative easing programs to combat the Global Financial Crisis and the Great Recession. However, we are not economists or economic historians. We run a trading service and are therefore concerned with where the markets will go next. This means that our key point of analysis is around where rates will go next, rather than what they did last week.

We were short gold going into last week’s FOMC meeting, but reduced our short exposure following the hike and consequent fall in gold. What happens with interest rates over the next year and beyond will determine how gold trades going forward. Therefore our analysis of the future of interest rates will be the most significant component in calculating the risk reward dynamics on potential new gold trades.

Connecting the Dots

 The FOMC meeting last week also included the release of the dot plot projections. These show where members believe key economic data series will be going forward, but also, and more importantly, show where members believe interest rates should be. These dot plots are thus vital for speculators in determining the future of interest rates.

The chart above shows how FOMC members believe interest rates over the coming years. The current implication is that rates will rise to 1.40% by the end of 2016, which would take four hikes of 25 basis points each. It is also implied that rates will rise another 100 basis points in 2017. If we believed that these projections would be realised, then we would be limit short gold. However, we instead hold the view that rates will in fact rise more slowly over the coming years.

Oil & ECB

These are two factors that will lead the Fed to tighten at a slower pace than the dot projections currently imply.

Lower oil has led to falling energy prices, but this is not the only reason falling oil prices have caused disinflationary pressures. Energy companies under financial stress have seen credit spreads widen and selling across the board in High Yield debt. This has increased the borrowing costs for the US corporate sector.

When this is combined with the fact that oil prices are lower, it is clear that new projects, particularly involving high cost shale, are becoming more and more unviable. This has hurt the jobs sector, which means that the multiplier effect must be considered. When the energy sector lays off or cannot hire a worker, that worker may not buy the new house they were looking at, which would have involved credit and a mortgage. This means that it is not just the salary that is lost, but future spending using borrowed funds as well.

The higher borrowing costs also in of themselves are likely to cause the Fed to hike at a lower rate. The widening credit spreads effectively increase interest rates for US businesses, which means it has the same effect as rates being higher. Therefore the Fed will not need to hike as fast as the effect of the hike will already be in play.

Moving across the Atlantic to the Eurozone, we believe that the ECB will have to embark on an expansion of their current QE program. Although the ECB recently lowered rates further, there is still a lack of inflation with core inflation also printing lower in the Eurozone. This means that further QE is likely to be needed and we believe that this will come early next year.

Such action will further weaken the Euro while strengthening the US dollar. This will generate more headwinds for the US economy by increasing the costs of US exports for foreign buyers, which will hurt the exporting sector and thus growth. A dampened growth rate will mean that inflationary pressures will be further limited, and therefore there will be less urgency for the Fed to hike.

Therefore it is likely that 2016 will see far less need for hikes than the Fed currently expects, so it is unlikely that we will see the projected 100 basis points of hikes.

No Christmas Catalyst

Now that the FOMC has passed and rates have risen, gold needs a new catalyst to move lower. However, there is little that can act as such a catalyst. The next payrolls print is not until January 8th, more than two weeks away, while other data prints are unlikely to move the metal lower. This means there is a significant amount of trading time wherein gold will be without a bearish catalyst.

There is instead the potential for bullish factors to push gold higher. Any type of risk off event will likely trigger safe haven buying in gold. Without a major bearish factor in play to counteract this, such an event would likely see gold rally.

We Sold The Rumour And Bought The Fact

 There is an old market saying of “buy the rumour, sell the fact”. Often assets trade higher ahead of significant positive events, but then begin to selloff afterwards. Since the beginning of the bear market in gold the metal has often rallied ahead of FOMC meetings or payrolls releases, but then sold off once the event passed and was shown to be bearish for gold.

Earlier in the year some speculated that the Fed hike would come with dovish connotations. During this time we increased our short gold exposure, gaining very favourable entry levels. The speculation that the Fed would be more dovish led gold to rally up until the October meeting when the Fed signalled that they would hike in December, after which it began to selloff.

This decline continued until the rate hike was announced. Following this gold initially moved lower, but then began to recover and regained ground on Friday, and has the potential to continue this recovery with no bearish catalyst to keep the price falling. However, we reduced our exposure on the day of the rate hike by taking a 70.21% profit on a short GLD call spread position. This ensured that we avoided Friday’s rally and the risk of it continuing.

Enjoy The Holidays

Following a tough year for financial markets we will take a brief break over the holiday period before returning in 2016. Currently our portfolio is running light with a considerable 75% in cash. This allocation gives us sufficient dry powder to action new trades in the upcoming year and ensures that we do not have any unwanted exposure on the books.

Our model portfolio returned 28.86% on closed trades in 2015. While this has not our best year and we have come in below our 52.31% annualized return since inception, we are content to have outperformed both long and short positions on the markets we trade. 2016 will no doubt hold another round of fresh challenges and we look forward to the opportunities next year will bring. If you wish to become a subscriber to receive trading signals as and when they are issued, please subscribe via either of the buttons below.

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Selling Downside Equity Protection, Will it Still Be Profitable in 2016?

Following the Global Financial Crisis central banks across the world aggressively loosened monetary policy. Rates were cut across the board and quantitative easing was implemented on a massive scale by the Fed, the ECB, the BoJ, and a number of other major central banks. This state of highly accommodative monetary policy drove equities higher almost without interruption as volatility was constantly contained.

We recognised that actions of central banks and the markets response had created a Global Central Bank Put, which meant that investors had protection against any downside movements in equity markets. At the start this year we published an article that discussed how one could take advantage of this by selling downside equity protection to enhance the performance of their portfolio.

Here we will look to explain how one could have implemented the strategy over recent months and analyse if it can be successfully used in the coming year, given the changes in the monetary policy environment.

Selling Downside Equity Protection

We believe one of the most effective ways to sell downside protection on equities is by selling longer dated out of the money vertical put spreads on SPY, the ETF that tracks the S&P 500. This strategy has a number of advantages that makes it more attractive than the alternatives.

We recently closed two short vertical put spreads on SPY, so will use these to demonstrate. On March 16th this year we sold December ’15 dated vertical put spreads with $195/$190 strikes for a net credit of $1.08. On the same day SPY closed at $205.58, which we will use as the equivalent entry price for a long trade.

The payoff diagram below illustrates how each position, the short put spread and the SPY long, would have performed relative to the SPY level upon expiration. This shows that the SPY long would have made a minimal profit even if equities had rallied to new all-time highs, whereas the short put spread would have gained the maximum possible profit of 27.55%. This means that SPY would have had to rally above $261.65 to begin to outperform the short put spread trade.

We respect that the put spread will show greater losses much faster on a pullback. At a SPY level of $190 the maximum loss of 100% would be reached for our put spread, while the SPY long would only be down 7.58%. At face value this may indicate that the SPY long is the better trade, as the downside risks are shown much more slowly, thus allowing one to exit the trade at a more favourable level if the market situation changes.

However, taking a closer look reveals a much more detailed picture. For our vertical put spread position to take the maximum loss SPY would have to be at or below $190 on expiration, which translates to approximately 1900 in the S&P. While the S&P did trade this low, the rebound was swift and powerful with equities having their best month since 2009 very soon after the correction.

The reason for this is the highly accommodative stance of central banks globally, which has ensured that equity markets are protected to the downside. Investors knew that, if necessary, the Fed would take whatever action needed to ensure that the slowdown in China (the trigger of the correction) did not cause another recession. This meant that soon after the correction had found its bottom, equities were able to rapidly rally back to their previous levels.

Our view that stocks would rebound quickly after a correction has now been proven correct. This view made the chances of the S&P being below 1900 at expiration extremely small. Therefore, although the maximum loss of our put spreads would be reached much faster than those of an outright long, the risk reward dynamics were much more favourable for the put spread as the expected losses were far smaller than the expected gains.

Time Premium Turns a Loser into a Winner

Suppose that one bought the underlying asset, SPY, to gain direct long exposure to equities. This trade would only perform profitably if the S&P 500 moved higher, regardless of how long it was held. However, a short vertical put spread on SPY actioned at the same time would make a profit if the S&P simply did not fall, as the positive theta component would ensure the time premium of the sold puts would decay to leave the position worthless at expiration. This means one could potentially bank the maximum profit without the S&P rallying at all, or even if it fell.

We had opened a second vertical put spread trade using the same expiry and strikes as the previous, but for a smaller net credit of $1.04 on April 8th, when SPY closed at $205.90. We took profits on both trades simultaneously on December 15th when SPY finished at $205.03.

This means that had one entered and exited a SPY long on the same days that we had traded our vertical put spreads, they would have lost money both times. This is in stark contrast to the 26.28% and 25% profits that we banked.

The reason for this difference is time premium. A long ETF trade neither accumulates nor loses time premium while it is open (although does earn dividends), the profit and loss depend purely on the current price level. However, options involve a theta component. When one is long a put or call this decays as expiration is approached, because there is less time for the option to move or stay in the money. Conversely, if one is short an out of the money put, then they are effectively paid the time premium as expiration approaches.

Shorting a put outright is an unlimited risk trade, so to avoid this we sold a vertical put spread. These trades are limited risk, but have the same attractive quality of negative theta. This means that the longer we were short vertical put spreads while they were out of the money, the more likely they were to expire worthless, the more time premium decayed, and the more likely we were to collect the maximum profit available.

Selling Downside Protection to Beat the Benchmark

In our article earlier this year we discussed how one could sell downside protection to enhance portfolio performance we considered how one could use these strategies to outperform the index as a benchmark. Here we considered a portfolio allocation of 20% to vertical put spreads on SPY, and the remaining 80% directly invested in SPY. The payoff diagram below illustrates the performance of such a portfolio, with 10% allocated to each of the vertical put spreads we sold.

This shows that allocating just 20% away from directly long stocks and towards vertical put spreads dramatically reduces the breakeven point. Rather holding SPY until the S&P rallied above 2050, one’s portfolio would show a profit 100 points lower at approximately 1950. Also, once the S&P moved above 1935, an SPY level of approximately $193.50, then the new portfolio would be outperforming a direct long. This outperformance would continue until the S&P reached approximately 2600.

This means equities would have to rally more than 25% before a direct long performed better. We believe the chances of this happening in the current market situation are limited enough to ensure that an 80% SPY long to 20% short SPY vertical put spread portfolio easily outperforms the direct long on a risk reward basis. If one had weighted their portfolio in this way with the trades we recommended to our subscribers, they would have outperformed the losing SPY long by 5.18%.

Will This Strategy Hold Positive Risk Reward Dynamics in 2016

Along with most we held the view that the first rate hike would come at this week’s meeting. Now that this hike has come, the Fed appears to moderately hawkish looking forward. Dot projections indicated rates will rise by another 100 basis points in 2016. The beginning of this tightening cycle means that the risk reward dynamics of selling downside equity protection is changing. With this in mind we exited both trades just before the Fed released their statement for the December FOMC meeting.

The phenomenon of the Global Central Bank Put was a result of highly accommodative monetary policy. With the Fed now tightening the effect of the Central Bank Put will very likely be reduced. This means that selling downside equity protection is less attractive in terms of risk reward dynamics, as the probability of selloffs being higher or prolonged has increased, which increases the expected losses.

However, monetary policy is not being aggressively or rapidly tightened in the US and most other central banks are still easing. This means that there are still potentially profitable trades to be made selling downside equity protection. ECB QE will likely be the key determinant of this.

The ECB failed to increase their current easing measures at their most recent meeting, despite market expectations. As a result it is likely the ECB will now have to expand their current easing program in early 2016. This fresh batch of QE is likely to support equity markets in the same way that QE3 did, but the effects are likely to be more concentrated on European stocks, particularly with the Fed tightening.

Therefore it is likely that European equity markets will be much more protected to the downside. This means that selling downside protection on European stocks likely has better risk reward dynamics than on US stocks going forward.

Our subscribers will receive our full analysis of how we intend to take advantage of selling downside protection next year. While this strategy has provided our subscribers with multiple profitable trades, including the two vertical put spreads just closed for 26.28% and 25%, the risk reward dynamics are shifting with the changes in monetary policy. Therefore if you wish to find out what we will be trading and when we will be executing these trades, please subscribe below.

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Will Lower Oil Prices Cause the Fed to Delay Tightening?

The FOMC has been moving towards the beginning of a new tightening cycle for a considerable amount of time. Throughout this year Fed statements and the accompanying press conferences have been preparing the markets for the first rate hike. Since the October FOMC various Fed speakers have signalled to the market that the first hike would come at the December meeting, which is this week.

Prior to 2015 employment had been the key focus for the Fed. Consistent jobs growth had allowed the tapering of QE3 and appeared to be paving the way for higher rates this year. However, inflationary pressures fell, causing the Fed to delay the first rate hike until now. They key reason for the decline in inflationary pressures has been the massive selloff in oil, which broke to new lows last week.

We believe the most likely outcome of this week's Fed meeting is a rate hike accompanied by an overall hawkish tone. However, the risk of a delay has significantly increased with the break in oil prices. The purpose of this article is to discuss how and why those risks have risen, and how to trade now that the risk reward dynamics have changed.

The Negative Effects of Lower Oil Prices

When oil prices first began to fall there was speculation that this decline would be positive for the US economy. Lower oil prices would mean smaller operating costs for firms and more discretionary income for households. This would lead to higher profits and increased spending, which would drive economic growth.

However, this argument was without respect for the US oil industry, and in particular the new high costs shale projects. Lower oil prices reduce profit margins for already operating oil producers while also making new shale oil projects too expensive to action. This means fewer jobs in the US, either by way of layoffs or lack of necessity with shale ventures being axed. This brings us to the multiplier effect, which is crucial when considering the impact of lower oil on the economy. We discussed this in depth in a market update sent to our subscribers last year:

“…if an energy worker losses a job, they may not buy the new house they were looking at, which would have involved a mortgage and credit. This means that the impact of a job loss is a lot more than just the salary as they employee may forego future spending with borrowed funds. Therefore, the multiplier impact has the potential to have an overall negative effect on the economy even in net oil importing countries, such as the US."

This means that although more people may feel the benefit of lower oil prices, the overall effect has the potential to be heavily detrimental to the US economy. This means that there is a sizeably increased risk that the Fed may delay the tightening cycle.

Can The Fed Delay Tightening?

The Fed has signalled a hike is coming this week and markets have largely priced this in. This makes it highly likely that Yellen will announce the first rate hike on Wednesday. However, this does not rule out that the Fed can still delay the tightening cycle as this is a process that will likely cover a number of years.

The tightening cycle can be delayed this week, even with a rate hike, by the language used and dot projections released. These will show the Fed’s plan for the future of monetary policy after the first hike, and thus will signal how the tightening cycle is likely to play out. If the dot projections are flatter than expected, this means that there will be less hikes next year and that rates will rise at a slower pace. This is a delay in the tightening cycle.

Last week’s break to the downside in oil reopens the risks to the economy that were prevalent during the initial decline. In response to this the Fed may believe it is prudent to delay the tightening cycle in the manner discussed above. This would calm market fears, shown by the fall in bonds, that both lower oil prices and a less accommodative monetary policy may harm economic health.

In the past Yellen has described lower oil prices as being transitory, and not the reason for a delay in rate hikes. However, the lack of inflationary pressures has been a key reason for the Fed not hiking sooner. The most significant hamper of these pressures has been lower oil, which has both directly lowered headline inflation and has had a negative impact via the flow on effects of fewer jobs. Therefore the break in oil may cause a delay without being explicitly stated as the reason.

Trading Gold’s New Risk Reward Dynamics

The yellow metal is struggling to make new lows with bond prices remaining firm. The Fed meeting this week will determine where bonds go from here, and will therefore move gold prices also. We expect the Fed to hike, but this is already largely priced in so its announcement is unlikely to move bond prices. Therefore the tone of the meeting and dot projections will be key, which the break in oil has increased the risk around.

If the Fed signals that more rate hikes will come and come often next year bond prices and gold will fall sharply. However, if the tone and dots are more dovish as a result of last week’s break in oil, then gold and bond prices are less likely to decline heavily.

We believe that the most likely outcome of this week’s Fed meeting will be a rate hike accompanied by hawkish tones for the future, but we respect that the risk of increased dovishness has risen. The long term direction of the Fed remains hawkish with rates still likely to rise going forward. This will still have a bearish effect on gold prices, so we remain bearish over the long term.

Given our bearish bias, we will look to use the break in oil to gain entry to gold shorts at a better level, with the view to fade gold above $1120 via various options strategies. Prior to the break, we intended to simply add to our gold shorts on any strength in the metal. These trades would then perform as a hawkish Fed drove gold to new lows.

However, now that the risk of a more dovish Fed has increased, the risk of gold rallying after this week’s meeting has risen. Therefore it is a better trade to keep powder try until after the Fed meeting. This allows for gold to rally on the back of a dovish Fed, and thus a better entry point for any new shorts.

We may also look to tactically reduce exposure to gold ahead of the Fed meeting. Gold has the potential to break lower towards the next major support of $1030 on speculation that the Fed will be hawkish. However, this does not change there is an elevated risk of the Fed being dovish. In this case we would look to tactically reduce our exposure by banking the profits currently showing on a number of our gold shorts.

Our analysis of this week’s Fed meeting and the exact details of any trades we make will be issued immediately to our subscribers. Therefore if you want to know what gold trades we will be making in response to this week’s FOMC meeting, then please subscribe below.


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Money Back Holiday Special 2015

Since its inception SK OptionTrader has enjoyed positive performance in each year, with 2015 being no exception. Consistent profits have resulted in our portfolio returns of 1248.41%, with more than 90% of our closed trades making money. To celebrate our continued success we are offering a limited time only, money back special to all new subscribers.

If you sign up for a 12 month subscription before Christmas, then we will refund the full cost of your subscription if our return on closed trades by December 1st 2016 is negative.

This means that if our portfolio finishes lower between now and December next year, then your SK OptionTrader subscription will have cost you nothing. However, if our trades make money then you will have paid for a service that has correctly forecast market movement, which is exceptionally valuable information.

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This time last year we offered the same opportunity to new subscribers. These subscribers have now experienced our performance first hand and have been provided with trading signals that have seen our portfolio grow 19.11% in 2015. It comes as no surprise that many of those who took advantage of our special offer last year are choosing to stay with us through 2016.

SK OptionTrader only issues trades that we make in our own portfolio, so our capital is on the line with every trading signal. Each position that we open is carefully considered to ensure that our number one goal, prudent risk management, is upheld. This ensures that the potential returns are maximised and any losses are minimized.

We back our trading strategies so confidently that we are willing to give SK OptionTrader away for free if they do not work.

The SK OptionTrader service has been active for over 5 years and has closed more than 178 trades in that time. Of these positions, more than 90% have made money. That’s correct, only 16 trades have ever lost money.

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Draghi Leaves Market Hungry For More QE

The most significant event for the markets last week was Draghi disappointing markets that were eager for an increase in ECB QE. Instead, the ECB President cut the deposit rate by 10 basis points to -0.30% and extended the current easing measures to March 2017, and beyond if necessary. Markets saw this action as insufficient with expectations across the board being that the ECB would sizeably increase their current easing measures, rather than just extend them. This was shown be clear declines in both stocks and bond prices, as well as a significant rally in the Euro.

Whatever It Takes

This is the key reason why the markets reacted so viciously to the lack of an increase in monetary easing by the ECB. In July 2012 Draghi famously made the “whatever it takes” comment regarding the preservation of the Euro. Since then markets have interpreted the remark to mean that the ECB will not disappoint on matters of monetary policy, that is, that they will act as expected. However, this interpretation should be used more carefully as it is easy to confuse “whatever it takes” with “whatever the markets want” when considering the ECB’s actions, which it appears markets have now done.

The comment was originally made in the context of stopping a breakup of the Eurozone during the midst of multiple debt crises that threatened to end the Euro. However at present, we are not on the verge of a crisis. While economic data, particularly regarding inflation, is poor in the Eurozone, it is not nearly as severe as situation faced when Draghi originally made the comment. Therefore, the response from the ECB was always likely to be more measured than “whatever the market wanted”.

Furthermore, the market had reached an almost excited state about a massive increase in ECB QE. Expectations had begun around the deposit rate cut that was actioned, but as this was priced in markets anticipated that further measures would be required. The consensus became that an extension to the current QE program would be put in place. Then some began to speculate that an increase in QE would be made, which in turn became widely expected. In short, the markets got ahead of themselves.

Draghi is prepared to do “whatever it takes” to ensure that the Eurozone does not break up, but given that we currently are far from that situation we cannot expect the ECB to act as if we are on the verge of a crisis. The action taken was that which the ECB deems as being required, which was not, and will not necessarily ever be, what speculators want.

Draghi Is Not A Day Trader

 Taking a step back, we will consider the action that was taken: a deposit rate cut and an extension of the current QE. This is still a strong response and a further increase in the highly accommodative stance of the ECB. The sky high expectations of investors were not met and the market has responded negatively to this, but the reality is that the action taken will very likely be sufficient for the ECB’s goals to be met.

The mandate of the ECB is not to satisfy market expectations. If central banks simply looked to take whatever action the markets had priced in they would effectively be making policy on public opinion, which would likely have dire consequences. Instead the ECB’s goals are price stability, full employment and balanced growth. This means that Draghi must look to the longer term.

Although day to day market reaction and confidence in policy making is important, the medium and long term response is far more so. As the ECB targets economic health, if the action taken last week sees this health improve, then markets will respond positively to that economic data. This reaction to economic data is the effective medium and long term response to last week’s announcement. Therefore, it is the actual effect on the economy that the market will react to in the long term, which also the target of Draghi’s latest measures. Accordingly, it makes sense that the ECB target longer term goals, as these are in fact far more important.

Conserving Ammunition

 In our view the action taken last week is a tactical win for Draghi. Market expectations were too high, which means that a negative reaction would likely have been seen if anything short of a massive increase in QE was made. Given this and that the Draghi did not want to massively increase QE, the ECB had the option to take the minimum level of increase in their accommodative stance. This means that they still have a considerable amount of easing left to use when they believe it will be more effective.

This month we will see the Fed hike rates. This tightening of monetary policy could push the USD to make new 10 year highs, and over the longer term will further increase its strength. This will likely undo the 2.6% rally in the Euro seen on the day the most recent ECB meeting. As external factors are therefore likely to weaken the Euro, there is less need for the ECB to directly intervene and take action for the same effect.

Using an increase in QE in early 2016 would also likely have a greater impact. This will allow time for the effects of the rate cut and QE extension by the ECB, and the rate hike by the Fed to begin to flow through to the economy. During this time the markets will move past the initial negative reaction seen last week. If more QE is then required, the ECB can act as such. If it is not, then the ECB has not wasted valuable economic stimulus that was unnecessary.

Trading ECB Policy

 The Fed hiking rates later this month is now all but guaranteed, which makes trading ECB policy more of a story for next year. We were long European equities in anticipation of more QE last week. However, we also sold topside protection on equities via out of the money call spreads when expectations became more extreme. We have since exited each of these positions for a profit.

From here we will look to establish trades based around the next significant ECB policy move. This is most likely to in early 2016 once the initial effects of the Fed rate hike have been felt. Therefore we will look to position our portfolio to take advantage of this through the rest of December and early next year before the action is fully priced in.

To take advantage of the ECB’s actions ahead of this, one must look to US markets and the Fed. The December Fed hike has been sealed by the strong payrolls print on Friday. This hawkish action will have a bearish effect on gold, causing it to continue to move lower over the long term. We have discussed in depth how fresh ECB QE would be bearish for gold, so the lack of it will likely have a bullish effect on the metal in the near term.

Therefore we will look to trade ECB policy by taking advantage of any near term rally in gold prices and shorting gold above $1125, before resistance at $1150 sets in. These short positions will appreciate as the ECB approaches the next big move, but will also gain value as gold falls towards $1030 on the Fed hike.

In addition to our trades on gold, we will also look to trade volatility. The highly accommodative stance of central banks had created the Global Central Bank Put that we have taken advantage of on multiple occasions. However, with the Fed tightening and the ECB taking a less accommodative stance than previously expected the effect of this put is decreased. This means that volatility has the potential to increase as the calming assurance that this put provides is diminished. Therefore the VIX is susceptible to a move higher outside of its current 15 to 20 range, which we will look to take advantage of.

We will signal our subscribers when we open these positions, providing them with the exact trades that we open in our own portfolio. We will also be publishing our regular market updates with further analysis of the future action for the ECB, the December FOMC meeting, and how we are trading gold, volatility, and other markets to our subscribers only. So for more information on how to become a subscriber, please subscribe via either of the buttons below.

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