Gold Options: Going to the Well Again

May.15.11 | About: SPDR Gold (GLD)
To all of the option sellers that have been "mining" premium in the gold market, there appears to be little reason to stop now
There are two markets where supply and demand fundamentals have gone out the window and where the value of the dollar and investor sentiment mean everything. Those markets are of course gold and silver. As silver has become the wild west of the commodities markets, the new pork bellies if you will, investors using the option selling strategy should focus their attention on the "gentleman's metal" - gold.
Dollar Lower = Gold Higher has been an effective formula for gold put sellers. However, this formula can also work in reverse.
I took a lot of heat for calling for a top in Gold on our Live Yahoo Finance interview a couple of weeks ago. However, that does not mean that I don't feel option sellers can't still make money from the put side of the yellow metal. Let me explain.
Most readers probably already know the driving story in gold. However, to review and probably oversimplify, it goes like this: The Fed prints money and keeps interest rates low. This drives the US dollar lower and spurs inflation fears. Investors (and everybody else) buy gold as a hedge against inflation (or against Armageddon, or the collapse of capitalism, or whatever reason they can think of.) The short simplified formula can then be reduced to this: Dollar lower = Gold Higher.
It doesn't always work that way on a daily basis however. But in a long term, sustained trend that is lined with political passions and economic convictions, it's a formula that has worked fairly well for the last 8 months.
Unlike silver, however, the gold rally has been a relatively orderly affair. Instead of quick spikes and dives in price, gold has offered more of a steady grind higher. Good price action if you're an option seller on either side.
The Fed, more or less, gave the green light to gold bulls last month when it confirmed that QE2 would be allowed to run to its regularly scheduled conclusion, while again denying that inflation exists. However, the dollar lower/gold higher formula works in reverse as well. Gold's correction over the first part of May is nearly perfectly aligned with the bounce in the US Dollar. Whether this is an early reaction to the end of QE2 or just a technical correction remains to be seen.
Option Selling Strategy
Gold isn't going to go up forever as evidenced by this month's reversal. But the Fed announcement should be enough to keep gold put sellers in business for a while longer. After June, the outlook becomes a bit murkier.
As we point out in the publication Option Selling for the Affluent, deep out of the money strikes often have the highest odds of expiring worthless. Therefore, gold put sellers targeting strikes in the $900 to $1000 per ounce range should be willing to go to the well again, as the chances of an extreme reversal in gold prices over the next 90 days appear to be small. This month's weakness in gold prices could be just the opportunity to sell additional put premium. But gold prices are likely to remain in a widely defined trading range for sometime.
Therefore, option sellers can look to strangle the gold market by also selling calls this month. Strikes as high as the $2100 - 2200 level will likely be offering good premium throughout the month. Speculators continue to appear willing to bet on astonishingly higher price levels. At those strike prices be willing to oblige them and take their money.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.