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Wednesday, August 12, 2009

Spread the Wealth with Gold: Three Longer Term GLD Option Strategies

When I was 16 years old, I took a vacation to Italy and purchased a gold chain. At the time I remember everyone telling me the price of Gold was too high, but I'm glad I went ahead and purchased it anyway... It was roughly $400 an ounce. Today gold is trading near $950 an ounce, and I only see it climbing higher. A United States economic recovery or not, I believe gold should increase in value over the next year or two.

Reasons for Buying Gold:
  • The U.S. economy recovers, but policy makers don't want to "jump the gun" and increase interest rates right away. Increased fears of inflation are sure to hit the market and speculation drives the price of Gold higher.
  • As can be seen with the price of crude oil and other commodities, gold also starts to rise in value as the U.S. dollar gets weaker. I assume the dollar will continue to get weaker as money is continually printed and pumped into the U.S. economy.
  • Increased levels of uncertainty about the future of the U.S. economy / stock market may influence many to hedge and purchase gold.
  • If these "recovery" talks are shot dead, and the U.S. economy starts to show greater signs of weakness, the speculation and probability of a U.S. credit downgrade should increase. As feared in May 2009, this caused the price of Gold to trade higher. The Google News Timeline below is for the term "United States Credit downgrade", as you can see it shows that there was an increased number of stories hitting the wire for the month of May. The chart below the Timeline is of the SPDR Gold Trust (ETF) (NYSE:GLD), which shows how speculation of a credit downgrade increased the price of Gold (obviously other factors may have increased Gold at the same time, but I remember this being a significant factor in driving up the price of gold) (click images to enlarge).

The Trade:
In this post, I will outline three option strategies / ideas to purchase gold. One allows you to create monthly income, and the other two are longer term approaches. To learn more about the risks, pricing, calculations, strategies, and options in general click here.

Gold Option Strategy #1: Income generating Diagonal Call Spread Option Strategy. Purchase the SPDR Gold Trust (GLD) March 2010 70 Call option, and sell the August 95 Call Option. The current theoretical option premium for the March 2010 70 call option is 2,340 per option contract. Selling the August 95 call option would lower the cost by 1.5%, and if the GLD is trading at or above 95 per share at August option expiration this position would yield 8.46% (in 10 days). If the GLD does not expire at or above 95 a share, the cost of the position will be reduced by 1.5% and it can be written for a similar strike for the September options expiration, lowering the cost of the position even more. The current September 95 strike call option for the GLD would lower the cost of this position by 5.8% and would yield the same return. Using this strategy month after month until the March options expiration will allow a steady flow of income (assuming the position is not assigned). It is important to monitor this position and purchase back the higher calls on weakness and selling them back out on strength (will return the most profit). It is also necessary to Keep track of the gain/loss, so it is not written too lower for a net loss at expiration.

*NOTE*: Writing the higher strike contract out with as many days until expiration and/or waiting to write it out as implied volatility is increasing, are two ways of receiving higher premiums.

Gold Option Strategy #2: Open a long vertical call spread on Gold using Leap 2011 options. Purchase the January 2011 60 strike call options. The current cost of opening this would be $3,440 per option contract. I would then choose to write a January 2011 130 strike call option against it. This would lower the cost of the position by 13.1%. If Gold is at or above 130 per share at the January 2011 options expiration this position would reach its maximum profitability and yield a return of 134.1% per contract, more than doubling the investment. In order to break even from this investment the GLD needs to be at or above 89.90 per share at January 2011 options expiration. This is a very bullish strategy on gold, for a less bullish approach see the next strategy.

Gold Option Strategy #3: Open a long vertical call spread on Gold using Leap 2011 options. Purchase the January 2011 50 strike call options and sell the January 2011 90 strike call options against it. This position would cost $3000 per option contract. As long as the GLD is at or above 80 per share at January 2011 options expiration this position will be profitable. The greatest return from opening a position like this would be 33.3%, and that is if the GLD is above 90 per share at January 2011 options expiration. If a short term rise in gold is expected, it may be a good idea to wait for a price spike in gold to write out a higher strike against it.

The strategies outlined above are bullish longer term ideas on Gold. Using call options allows you to open positions for much less while receiving the majority of the gain (until delta is 1.00 like in strategy #3, the contract will increase $1 for each $1 increase in share price). However they include the risk of losing more (in terms of %) if the GLD drops below the indicated purchase (lower of the two) strike price.

These are just some examples and not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

The reason option volumes have surged in the last 5 years is because they are a great way to hedge your portfolio as well as create income off of your shares (click here to see annual options volume chart).

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