Covered Call Options: Generating Income From Owning Gold

Nov.24.11 | About: SPDR Gold (GLD)

Most investors would like to have at least some portion of their money invested in gold. After all, over the last 10 years the long term trend has been steadily up, and with all the uncertainty in Europe, China and elsewhere, owning some gold makes sense. But investors who invest for income, and rely on that income, face a dilemma: gold itself doesn’t produce income, and gold mining stocks typically pay only modest 1-2% dividends. Even BHP – the Melbourne-based natural resources giant with some gold interests – yields just 3.0%. So what’s a gold investor who needs reasonable income to do?

The answer is a proven, conservative strategy of buying the SPDR Gold Shares ETF (NYSEARCA:GLD) and selling covered call options – called this because you’re ‘covered’ because you own the underlying security, and ‘call’ because it gives someone the right to ‘call away’ the security from you - against those shares. GLD is an unleveraged ETF which owns gold bullion, is managed by State Street for a modest 0.40% fee, and is rated 5 stars by Morningstar.

This strategy can consistently produce a current yield of 5% or more, and still enable you to profit if the price of gold falls. Buyers of options face an inexorable enemy – time. As time moves on option prices –all other things being equal – decline, so it’s better to invest with Father Time by being the option seller rather than the buyer. Let’s examine how this can work for you.

GLD closed recently at 167.82, in the upper reaches of its 12 month range of 127-185. Beta – the standard measure of volatility – doesn’t capture GLD’s moves as its five year beta is just 0.32. This low figure is due to the fact that gold prices correlate most closely to the U.S. dollar, and gold is often seen as an effective hedge against a weakening dollar. But statistically GLD is quite volatile with a standard deviation of 20-22 depending on the time period, somewhat higher than the stock market average of 18-19. This is important because it indicates that options will price in substantial price movements, and will be higher relative to GLD’s price.

If we buy GLD at 167.82 and our target is a minimum 5% annual yield, then we need $8.39 a year in income. Looking at the tables of option expiration dates and strike prices, we need an expiration a year or so out, and a strike price – the price at which someone can buy GLD from us by virtue of the option we’re going to sell them – above $167.82. Let’s look, then, at the January 19, 2013 expiration [427 days away] and examine option pricing at $170 and above until we find one priced at $8.39 or higher. Since we’re going to be selling the option we should look at the ‘bid’ prices. We see that the first one higher than our target is the 215 option with a bid of $9.05.

Now that we have a potentially workable option, let’s see how a covered call strategy would work. Say we buy 100 shares of GLD and pay $16,782. We then sell one covered call contract for the Jan 2013 $215 strike price, and for that we receive $9.05 per share, or $905 in total. This commits us to hold our GLD shares until the option expires; we’d need to buy the option back at the then-current price before we could sell GLD. What kind of return does this give us if GLD remains flat, goes up, or goes down?

If GLD stays flat, or goes up but doesn’t reach $215 by Jan 2013, or goes down, the $905 we received for the option gives us an effective current yield of [[$905/427 days] x 365 days]/$16,782 = 4.61%. Unfortunately, this yield would be below our 5% desired threshold, so let’s reject it and look for another.

The $205 strike price option has a bid of $10.85, so let’s quickly do the math. [[$1,085/427] x 365]/$16,782 = 5.53%. Excellent! Let’s take a more detailed look. If GLD goes up higher than $205 it’ll be called away from us by the option buyer, so that’s our maximum return. At $205 we’ll make [$20,500 - $16,782] = $3,718 profit on the sale, plus $1,085 from the option sale for a total of $4,803 in 427 days on our investment of $16,782. Our annualized return is [[4,803/427] x 365]/16782 = 24.46% - a very attractive return!

If GLD stays between $167.82 and $204.99, the option will expire worthless and our current yield will be 5.53%, we’ll retain our 100 shares of GLD, and on January 20, 2013 we can do it all over again by selling another option.

But what happens if GLD instead goes down? Let’s take a look at that scenario. If GLD goes down, our breakeven level is $167.82-$10.85 = $156.97. Because we received the $10.85 a share in cash up front, our net investment is $156.97. If GLD stays at or above that level, the option will of course expire worthless, and in Jan 2013 we can generate more income by selling another option. If GLD drops below $156.97 and we want to get out of the position, as time passes and hope fades the option will go down in price. At that point we can buy back the option and lock in that gain, then sell our GLD shares at a loss.

Selling covered calls is an excellent proven strategy to increase or create dividend income. It works very well when you own high quality underlying securities and sell options above your breakeven price level. While the same strategy can be implemented with almost any stock, it works especially well with gold because the emotional attachment many speculators have for the metal results in consistently expensive option prices. Most times the option expires, you keep the stock, and you can do it again. However, you do give up the potential for a home run.

In my experience, just as Billy Bean in Moneyball found that getting on base was the single most important statistic - not hitting home runs - selling covered calls and generating strong income levels is the equivalent of hitting .300 and winning championships year after year.

Disclosure: I am long GLD with corresponding covered call option positions.