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 expirations 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. To learn more about OptionMaestro.com strategies click here.

Disclosure: No positions

Comments

[doubleguns:]

This is like banks buying derivatives. Too complicated for most to get it right and it risks becoming worthless. If option #1 never gets to $113.70 you loose everything.

Physical asset might go down but will almost never become worthless.

May 13 09:29 AM

[Whippet:]

I agree, doubleguns, if this were one's only exposure to gold. I have a two-tiered strategy- I'm accumulating physical PMs as an insurance policy, along with other items required if/when they are necessary as a sole store of wealth. I'm also playing the "business mostly as usual" side, hoping that despite the current madness we emerge with a stable society and better policies. In this case, plays like this can be a good hedge bet against inflation in the next few years. In the context of a rounded investment plan.

Personally, I like the plays but will wait for the 2012 LEAPS, which will be available in the next month or two. Should be able to pick up a similar structure for an extra 30-50 bucks a spread.

May 13 09:53 AM

[doubleguns:]

Whippet, my concern is if things don't go well and we depress for some time. That play will lose everything for someone in it. PM's will just go down/up/sideways who knows but will not become worthless. For an educated investor its fine to play but some poor wit is going to follow this lead and get killed.

Thats why I wanted to point out the down side so they had ALL the information.

We never know what our comments might do to some NEW inexperienced/incompetent investor out there that has been crushed and is looking for a quick fix to get whole again and just looks at potential return without understanding risk.

For you, me and a lot of others out there this is a game we can afford to play since we have PHYSICAL assets too.

I like your LEAPS12 idea better. That additional time I believe will be needed.

May 13 10:26 AM

[Anomander:]

Sounds good...but there is NO SUBSTITUTE for owning hard physical gold. The US dollar will crash. There will be double-digit inflation. The boffo's stand on the wrong side of capitalism to be able to rein in inflation....thus gold and silver will become the only asset worth anything.

Seriously, expect Washington's left-of-center administration to do *anything* but the right thing. They will NOT cut taxes, eliminate the capital gains tax for a couple of years, pare back on their pie-in-the-sky social programs. They will NOT abandon their dream of universal socialized health care. There's more, but I think you get the idea....

May 13 11:15 AM

[Anomander:]

Why hold ETF's (fools gold) when you can hold the real item? Baffles me. Now, having said that...sure, once you salt away your stash of hard gold and silver, by all means stretch out and invest in the markets and that includes ETF's.

The US is heading in the wrong direction philosophically, so there is no way they will be able to pull out of the double-digit inflation heading their way.

Let's size it up. China and others have lost their appetite when it comes to rounds and rounds of debt selling. Obama will not allow off-shore drilling. He won't even allow coal in the US - evidenced by the closing of 300 mountain top mines. He will want to push ahead with plans to foist an expensive agenda upon the American people - socialist medical plan, anti-nuclear, anti-off shore drilling...basically anti-energy.

He wants to adapt the Spanish Plan when it comes to green energy. That plan is a DISASTER if anyone has taken the time to study it.

No way an administration such as the one we have now in Washington has the core direction to make the economy as the number one issue at the table.

Instead of gutting pie-in-the-sky social experiments, Obama will spend billions on them. Instead of imposing a two year moratorium on capital gains tax...he'll impose moratoriums on traditional energy sources. Instead of cutting taxes, he will raise taxes. Instead of letting weak businesses fail and get out of the way - he'll spend billions propping them up.

Owning hard gold is the only way a market savvy investor has even a chance for future security.

May 13 11:25 AM

[MILESCFA:]

I put on several similar LEAP verticles in stocks near the mkt lows. While the market makers were more than willing to trade the other side when they needed negative Delta, I have had a hard time exiting the trades. I assume that market makers can easily buy Delta because of the huge numbers of people selling calls against long positions, so trading out of my positions have been difficult.

I'm not sure if this applies to gold, but you should be aware of the potential illiquidity. Nonetheless, this can be a good strategy but I prefer to employ it when an asset experiences a significant drop in price. Otherwise you have to be very bullish (I'm not wild about the option pricing models, but this strategy currently has about a 20% probability of expiring in the money, so getting out is a critical aspect since there's a 42% chance it will trade above break even and an even greater chance of entering profitability prior to expiration).

Doubleguns+, I hesitate to comment because most people don't handle criticism (esp. gold bugs), even if constructive; however, to say it "might become worthless" and the physical asset will "almost never become worthless" shows a lack of understanding that this is a leverage play (as are all options). If you want to risk the same $370 in GLD vs the #1 option play, you can buy 4 GLD shs, so to make the same $2630 in the "physical asset", GLD would have to go to ~750 (equates to gold at $7,500).

Thus, this option play is a high leverage and therefore high BUT LIMITED risk strategy. Liquidity should be a crucial concern, since it'll probably trade into a profit.

(NOTE: A friend of mine trades in the S&P futures pit and owned puts prior to the 1987 20% crash; he was MAD because no one would offer him anything near the value of his puts... they were TOO DEEP in the money, hence they were TOO ILLIQUID).

May 13 11:31 AM

[Whippet:]

Good word. I would assume people dabbling in options would at least see this as a "safer play", for the options spectrum. I see options as a way to limit risk, leverage returns, and hedge long stock, but only for a small portion of my overall portfolio.

The safest end would be to just buy ITM GLD leaps- there, you can choose your risk level and still get leverage. In any event, it makes more sense than holding long GLD shares which pay no dividend.

The better true inflation hedge play would be to sell ATM LEAPS puts, and buy OTM LEAPS calls with the proceeds. Sell one 90 Jan 2011 Put today for 13.00, Buy two 150 Jan 2011 Calls for 5.40 each. This has the same downside (below 90) risk as holding 100 shares of GLD. Between 90 and 150, it nets $220 in premiums minus the opportunity cost of collateral. Over 150 in Jan 2011, the returns skyrocket. At a $2000 1/11 gold price (more probable than some may think), this trade nets $10,300. This can be tweaked at all points.

A pure synthetic play (long call/short put at same strike) is still preferable to holding long GLD shares long term. Less capital commitment, same counterparty risk. But no substitute for having SOME physical PMs on hand.


On May 13 10:26 AM doubleguns wrote:

> Whippet, my concern is if things don't go well and we depress for
> some time. That play will lose everything for someone in it. PM's
> will just go down/up/sideways who knows but will not become worthless.
> For an educated investor its fine to play but some poor wit is going
> to follow this lead and get killed.
>
> Thats why I wanted to point out the down side so they had ALL the
> information.
>
> We never know what our comments might do to some NEW inexperienced/incompetent
> investor out there that has been crushed and is looking for a quick
> fix to get whole again and just looks at potential return without
> understanding risk.
>
> For you, me and a lot of others out there this is a game we can
> afford to play since we have PHYSICAL assets too.
>
> I like your LEAPS12 idea better. That additional time I believe
> will be needed.

May 13 03:51 PM

[doubleguns:]

I have no problems being corrected. My thoughts were if gold prices go down the option is worthless.

Physical asset is still worth something.

If I am not getting it PLEASE let me know because ignorance can only be fixed through education. I got tired of being ignorant a long time ago but still find that I am still ignorant at times and it has cost me money.

I am really, really trying to avoid any more of that right now.

May 13 03:58 PM

[5142152-337:]

The author obviously is comfortable with that method of playing the game. My take: Buy PHYSICAL gold and silver. Its EASY, and you can hold it in your hand! The real stuff, not some piece of paper that MAY BE WORTHLESS when the time comes to sell.

Get a safe, and run, not walk to your nearest precious metals source.

May 13 05:05 PM

[H. E. Canada:]

All of the option strategies discussed here have some merit if one believes BIG inflation is coming in the next 18 months, that the US dollar will lose relative value, and that interest rates won't be high enough to draw investors away from Precious Metals.

As Whippet says, one could wait to implement some of these or all of these strategies when the 2012 LEAPS come out later this year, if one prefers a longer time horizon. Then again, since none of us can predict what will happen when, one may ladder their LEAPS using these strategies for both 2011 and 2012 and perhaps mitigate some of the timing risk, as is often done with investments in Certs of Deposits, etc.

Yes, physical assets are a part of a good plan, and, yes, LEAPS provide a reasonable and limited risk, as leverage also has an appropriate role when managed correctly. Know you exits before you enter the trade, keep your eye on your tolerable loss limits (using stops where appropiate), work your plan, and don't let emotion overrule logic.

May 13 09:33 PM