Using Options To Protect The iShares Gold Trust ETF

Sep.21.11 | About: iShares Gold (IAU)

A few weeks ago I started a series of articles on using Options to hedge portfolio holdings. This is another installment in that series.

My past articles were primarily devoted to providing Portfolio Protection for a diversified portfolio. I want to diverge from that theme a little and discuss how I deal with specific stocks that are “gnawing away” at me.

The example I like to use is gold. Many investors have difficulty with this. On the one hand gold has had a remarkable run and sits as if perched to fall. On the other hand global concerns and pundits say the run is far from over.

I think those that own gold ETF’s wonder if they should sell. Contrast this with all those that don't own gold wondering if they should be buying. So, I think this makes it ripe for a discussion on protecting through options. For this analysis I will use the iShares IAU ETF rather than the SPDR GLD ETF.

The reason is that the GLD ETF trades around $175 and one option is for 100 shares. Therefore each option reflects $17,500 in GLD value. Options don’t sell in fractional amounts (you can buy 250 shares of GLD, but you can’t buy 2.5 options). On the other hand IAU trades at around $17.50 so each option covers only $1,750 in value and provides more flexibility (Instead of buying 250 shares of GLD and worrying about compensating for the ½ share problem, I can buy 2,500 shares of IAU and 25 options.) GLD seems to track IAU pretty closely, so you could own GLD and protect it with “surrogate” IAU Options.

Let’s look at 3000 shares of IAU, trading as of this writing at $17.62, for a total exposure of $52,860.

My first step is to buy a long dated put as close to the money as I can. Since IAU is trading between $17 and $18 I must go either up or down in the strike price. Without any particular reason I’ll go for the $18 strike. My second step is the expiry date. I like to buy long dated puts and the longest offered for IAU is April 2012.

Now, how many options to buy? This varies on circumstances, between 25% and 50% MORE than the current exposure. In this case 30 options (each option is 100 shares) would cover the current exposure but I will buy 40 options (33% extra).

The April 2012 put at $18 costs $1.85 so my total cost for 40 options is $7,400.

The next part of my strategy is to lower the cost of these puts. In order to do that I will sell ten front month puts to generate income. Since I bought an extra ten puts at the start, this purchase is, in itself, protected from ultimate loss.

The October $18 put sells for $.75 so ten puts sold will generate $750. If nothing changes, I have nine months till expiry so I’ll receive a total of $6,750. This is close to the $7,400 the puts cost, but the put I bought was slightly (38cents) “in the money” at $18. So, if IAU closes down in April I will pick up this additional amount of about $1,000. No net cost over the nine months.

In summary, if IAU closes down from $17.62 in April 2012 I will have recovered my long dated put cost by selling the short dated puts and the long put will be in the money for whatever value IAU has lost.

There is one additional component I add to this strategy, but it is completely optional. If I am uneasy about Gold at these prices I’ll probably increase my uneasiness each time it climbs. I make money, but I worry more. In these situations I decide ahead of time the price where I’ll just close out my position and bank my profit.

In this case I look at the April 2012 calls. I can buy the April $18 call for $1.40 and sell twice as many April $20 calls at $.75 (ratio spread).

The purchase of 30 calls is $ 4,200 and the sale of 60 is $4,500 for a net credit of $300. Add this to my downside protection.

What if IAU goes up by the April expiry date? Well, if it goes up but closes below $20 (a 14% move) I make the move on my original 3000 shares and I double it as my $18 calls move up.

If IAU goes above $20, my long $18 call will continue to gain, but the $20 call will “Zero-Out” that move AND any further appreciation in my original 3000 IAU shares. Summarizing, I will double my gain between $18 and $20 (increasing my return from as much as 14% to as much as 28%) but will cap it there on my original shares..

Since I’m somewhat uncertain about Gold to begin with, I’ll happily take this kind of profit. On the other hand if I was particularly fond of the stock and wanted to keep it (like Apple), I wouldn't want to limit myself this way.

In conclusion, this strategy if employed completely will protect your holdings in IAU against any decline and the optional ratio spread offers some upside leverage as well.

Remember though, this "dual strategy" is most effective on stocks that I'm somewhat uncertain about, but willing to hold or buy.

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