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Wednesday, May 13, 2009

Will Gold Continue to Shine? A Bullish Option Strategy

With the amount of money being printed today, I think we'll see rapid inflation within 18 months. The Fed has stated they'll fight inflation by raising interest rates once they believe inflation is a threat. But how healthy will the economy be when inflation becomes a threat, and will it be safe to hike interest rates? A sure way to hedge against inflation is gold. But who wants to commit too much money to gold, with fears of deflation looming as well?

I think the best way to hedge against inflation is to play an option call spread. This gives me little downside risk, with a potential big upside. There are many ETFs to look at, the most common is the GLD which seeks to track gold’s performance. Another is the UGL which seeks to track gold 2X, (double leveraged ETFs are dangerous as it is a double leveraged ETF; read more about Double leveraged ETFs here).

I assume gold to be as high as $1500 within 18 months so my time frame will be playing the Leap 11 option contracts. You'll want to adjust strike prices and option expiration's according to where you think gold is going and when.

I will show you a couple of my own ideas below:

Strategy #1: Buy the GLD Leap 11 $110 Call and sell the GLD Leap 11 $140 Call. To open this strategy it would cost about $370 a contract, with the potential of netting $2,630 or over 700% assuming GLD expires at or above $140 a share in January 2011. The break even point on this is the GLD at $113.70.

Strategy #2: Buy the GLD Leap 11 $100 Call and sell the GLD Leap 11 $130 Call. To open this strategy it would cost about $530 a contract, and if GLD expires at or above $130 come January 2011 expiration, the profit on this strategy would net $2,470 or 466%. The break even point is $105.30 for the GLD at Jan 11 expiration.

For the UGL it is hard to predict where it'll be in 18 months; therefore, I have not been able to come up with a good strategy on it.

If you're bearish on gold and think we'll enter a deflationary spiral, you may want to implement the same type of strategy only with a bear put spread.

I have not opened any of these positions yet, but I intend to within the next 3 months. I am anticipating gold to pull back slightly on deflationary fears, so if and when that happens, that is when I'll jump in. In my opinion, I think we could see gold near 850 an ounce before it really takes off past 1000. I think having some gold is a critical hedge for your portfolio, and playing the option spread is a cheap way to do so. As stated before you'll likely need to adjust strike price and expiration, based on your opinion of gold.

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