Note: This is a post from our weekly stock selection email published by InvestorPlace Media. If you like it – you can sign up for email alerts like this each week. We will also be publishing them on our site here.

Trade Idea: Buy GLD after breakout on ECB catalyst; look for move past $159 to confirm bullish pattern.

Option Alternative: Buy to open the January 2013, 159 Calls when the stock breaks above $159 per share.

Dividend yields, a defensive business model, room to expand in emerging economies, a savvy management team – gold offers none of these. Strictly speaking, it can’t be valued as an investment because it produces no cash flows or the potential for any. What it does bring to the table is an insurance policy that acts as a counterbalance to the threats born to a portfolio every time a central banker says that any measures will be taken to protect a monetary union, stimulate an economy, or spur activity towards full employment.

So when Mario Draghi didn’t just hint last week that the ECB would stand behind the euro but made it unquestionably explicit, gold rallied as an almost law-of-physics reaction. Draghi said that the ECB would do “whatever it takes” to save the euro, which came as much of a surprise to fellow ECB officials as it did to traders. Markets around the world rallied on the comments and gold jumped $39 in the four days since the comments to $1627 an ounce. Although he did not go into much detail or explain the planned mechanisms for bolstering the euro, the presumed goal would be to lower borrowing costs for Spain and Italy sufficiently to buy time for the Union to fix its structural weaknesses, get their economic growth engines revving again, and pare down the deficits of the most troubled countries. Leave aside for a moment whether Draghi’s massive bond buying plan would be effective and whether he could garner enough of Germany’s support to go along with it. Boiled down, a central bank has only so many tools it can employ and printing a lot of money is an all-time favorite when things get really dire. So despite the many euphemisms coined in the financial press to dress up the essence of the activity, when traders and investors perceive renewed central bank commitment to print more money, they understandably get eager to click the gold buy button.

No surprise then that the ECB chief’s comments helped gold, and its exchange-traded tracking fund, GLD, break out of a long consolidation pattern that has been forming for nearly all of 2012. The breakout has been minor but given the length of time GLD has been consolidating, could it be the beginning of a new sustained trend?

But first, a little background.

The Nuts and Bolts of the SPDR Gold Trust

SPDR Gold Trust is an exchange-traded fund that represents an undivided beneficial ownership in the trust’s assets. The sole assets of the fund are in the form of allocated gold and, occasionally, cash. GLD was designed to allow investors to participate in the gold bullion market without the necessity of taking delivery of physical gold, and to buy and sell that interest through the trading of a security on a regulated exchange. Through the means of an exchange traded security, the fund’s objective is to eliminate the obstacles of access, custody, and transaction and shipment costs that precluded many investors from buying gold directly.

The price of GLD is intended to represent 1/10 the price of an ounce of gold, net of fund expenses. The gold that underlies GLD is held in the form of allocated London Good Delivery bars in the London vault of HSBC Bank, USA. The Trust currently holds nearly 1,250 tonnes of gold (that’s 40.14 million ounces), making it the largest physically backed gold exchange fund in the world as well as the largest private reserve anywhere. While the vaults may look rather indistinguishable from a Costco warehouse, with over $65 billion worth of bullion bars stored inside, forklift operators have a more rigorous background check to go through.

Rumblings of New Stimulus

There is no doubt much of the euphoria that propelled GLD to over $180 in the summer of 2011 has long since dissipated. In its place, a prolonged period of uncertainty has shaken out short term momentum players and tested the resolve of long term bulls. The $149-150 level has been a crucial support level that has stood its ground up to this point but has also been increasingly challenged over the last three months. Rallies that reached lower highs on each sequential turn showed bulls losing steam. As the Fed remained in its holding pattern and stayed its QE3 hand, GLD’s price action seemed to suggest a sense of deflation (no pun intended) on the part of bulls and encroachment on the part of GLD shorts.

GLD 18 month

SPDR Gold Trust: Chart Courtesy of MetaStock

Draghi’s comments have at least stimulated gold prices in the very short term and broken the downward trending consolidation pattern – for now. Because of the rally, gold spot prices have risen 1.15% so far in July, putting the metal at a 3.7% gain YTD (although still down -15.6% from its 2011 highs).

But GLD is not out of the woods yet. Follow through will be key. Many technicians note that $1640 on the spot price is a key resistance level on the upper end – surpassing and holding this level will indicate the follow through many gold observers need to be convinced that gold could have renewed legs. Several prominent banks, including Deutsche Bank and Morgan Stanley, have lofty price targets on gold, projecting that prices of $1,800 to north of $2,000 could be seen in 2013. These outcomes, however, are precipitated on economic conditions worsening in both the US and in Europe, thus necessitating further sweeping action on the part of central banks.

GLD 3 month

SPDR Gold Trust: Chart Courtesy of MetaStock

Option premiums shot up on 7/26, the day of Draghi’s comments, and have stayed elevated, indicating that traders expect volatility to increase in the coming weeks. Option volume that day was near 260,000 vs. average volume of 68,000. The put:call ratio was 1:3. Also note that the correlation between gold and the EUR/USD for the month of July was 0.72. Hence it will be difficult for gold to mount a sustained trend if the euro begins to break down and head back to new lows.

Expect some tug of war here between two magnetic technical poles, bears pulling GLD back down towards the $150 support, bulls pushing for another key breakthrough at the $158-159 level. Implied volatility is likely to stay elevated ahead of the 2-day FOMC meeting that concludes on Aug. 1. Speaking of tugs of war, there is still division among Fed governors about the need, and likely effectiveness, of QE3. But surveys this week among traders and money managers indicate a marked increase in the expected likelihood of QE3, up to 78% from 33% back in April. At this point, it is impossible to divorce the price action in GLD from the verbal indications of the Fed and ECB. But this GLD squeeze and initial breakout may be good reason to play the ETF in anticipation of further monetary action. A definitive stop just below $149 – representing only a -5.4% loss if things go south – is a worthwhile risk for the insurance policy GLD represents if central bank action begins to heat up again.

As an alternative, intermediate term investors could consider an outright long call position with a longer dated expiration. If the stock breaks above $159 we would recommend the at the money strike. If such a break occurs within the next 5-10 trading sessions we would recommend the January 2013, 159 Calls for $9.50 per share or less. It is possible that such a break could happen very quickly so a conditional order set to trigger when the stock’s price moves above $159 and into the $159.50 range could be set to automatically enter the position. The long call will provide theoretically unlimited upside, but would be useful for traders hoping to avoid the whipsaw risk of using a tight stop loss when buying the stock alone.

Chart courtesy Finviz. Click to open in larger window.

This is not investment advice. Learning Markets, LLC is not responsible for errors or omissions. Please be sure to read our disclaimer.