Why Bother with SPDR Gold Shares Options?

By Brad Zigler

In late May, we ran a column announcing the debut of option trading on the SPDR Gold Shares (NYSE Arca: GLD) grantor trust (see "Options for Options"). Since then, we've received a fair amount of comment on gold ETF option trading, ranging from "So what?" to "That's crazy!"

Most people seem to think that gold ETFs are risky enough thankyewverymuch. Adding another layer of risk to the gold equation doesn't seem to make much sense. There are options, however, that offer decidedly stock-like exposure together with the leverage of a derivative.

Long-term options known as LEAPS (Long-term Equity AnticiPation Securities) can be used to advantage by gold bulls in a number of ways. The simplest application relies upon the inherent leverage of options to yield more bang out of every buck tracking gold.

You can find a LEAPS call, for example, that conveys to its owner the right, but not the obligation, to purchase 100 shares of the GLD trust at $70 any time through the third week in January 2010. Keep in mind that GLD closed at $91.47 a share Friday. This option gives its owner the right to obtain GLD shares at a $21.47 discount to the market price. Mr. Market rarely gives away advantages so large, so you can expect to pay up the "in the money" amount, plus an extra premium for the 567 days remaining in the option's life. After all, time is opportunity in option land: the opportunity to go even deeper in the money.

At present, the call's offered at $26.60 a share, or $2,660 per contract. If you wanted to buy 100 GLD shares outright, you'd have to pay $9,147. An investment that size could, instead, snag three of the LEAPS calls, allowing you to draw upon the appreciation potential of 300 GLD shares rather than just 100. At least until January 2010.

If GLD's at $100 by the third week of January 2010, you could expect a 9.3% profit, before commission, on your ETF purchase. At that same price level, your LEAPS calls, though, would return 12.8%:

Buy 100 GLD At $91.47 Buy 3 GLD $70 Jan 10 LEAPS Call at $26.60 Cash Required $9,147 $7,980 Breakeven Price $91.47 $96.60 Value With GLD at $100 $10,000 $9,000 Resulting Profit $853 $1,020 Total Risk $9,147 $7,980

The risk/return patterns for the shares and the calls aren't congruent, however. Losses on the call are limited to the premium paid, no matter how low GLD trades. Because of the premium, however, the call's breakeven point on the upside is higher.

GLD LEAPS Call Vs. Shares

The leverage of a LEAPS call can also be used as an alternative to a margined purchase of GLD shares. Suppose, for example, you're considering purchasing 100 shares of GLD in a margin account. You'd need to put up half the cost of your shares, or $4,574, and borrow the balance of the purchase price, some $4,573, at the broker's loan rate. Let's say that's 4.25% per annum.

You could, instead, purchase the $70 LEAPS call on GLD expiring in January 2010 for a $2,660 premium.

Here's how the two strategies compare if they were held until the call expiration date:

Buy 100 GLD At $91.47 (50% Margin) Buy 1 GLD $70 Jan 10 LEAPS Call at $26.60 Cash Required $4,574 $2,660 Loan Required $4,573 $0 Carrying Cost $302 $513 Breakeven Price $94.49 $96.60 Value With GLD at $100 $10,000 $3,000 Resulting Profit $551 $340 Total Risk $9,147 $2,660

The total risk of owning the LEAPS call, at $2,660, is less than a third of the risk associated with owning GLD shares, i.e., $9,147, themselves. The up-front cash needed to initiate the LEAPS position, as well, is 42% less than that required to open the margin purchase.

However, the cost of carrying a LEAPS call is 70% higher than that of purchasing GLD on margin. Carry costs for the margined stock position consists of interest on the funds borrowed to finance the stock purchase. The carrying costs for the LEAPS call is the time value embedded in the purchase premium. Time value is the premium paid in excess of an option's intrinsic worth. Put another way, it's the premium above an option's in-the-money amount. A $70 call is $21.47 in the money when the underlying shares are trading at $91.47. The time value, then, of an option with a $26.60 premium is $5.13 a share, or $513 per contract. Time value wastes away as an option approaches expiration.

Note, too, that the LEAPS' breakeven price is $2.11 per share higher than that of the margined GLD purchase, after including the margin account interest and the LEAPS purchase premium.

The return obtained by the margined purchase on GLD's move to $100, at 12%, is a slightly higher purchase than the 11.3% profit achieved by the call. Pretty stock-like, that.

Of course, there's a lot more to options than just the cursory examination offered here. More details can be obtained from the Option Industry Council, but you can get a sense from the foregoing that some options, at least, can behave very much like their underlying shares while they reduce capital commitments and overall risk.

How bothersome is that?

Comments

[bearfund]

It depends what kind of risks you're worried about. The only risk in holding physical gold is that the things you want or need to buy will continue to be priced in something else and that something else will appreciate relative to your gold. Most of us don't consider that risk very serious given negative real interest rates and explosive monetary expansion, to say nothing of rising government meddling and the ever-present threat of war.

Options are a different kettle of fish - and high on the list of risks is the risk that gold itself is so good at insuring against: counterparty risk. The two main advantages of gold are its natural scarcity and the complete lack of counterparty risk; physical gold does not in any way represent anyone's obligation to its holder. All the value in the gold was created in the past. Neither of these advantages applies to options, especially calls. The very circumstances in which the notional value of your calls would be greatest are those in which your counterparty is most likely to default. It makes little more sense to write calls against your gold: the cash they will generate is not worth the risk of losing your asset at the very time you may need it most.

Traders in GLD options must surely be gold bears, fools, moneyed types so filled with hubris that they could never imagine their own financial system collapsing, or nihilistic speculators convinced that in extremis even the most dependable form of money will surely be worthless. I guess I don't see any point in joining any of those crowds, so I'll stick to my physical holdings. If you feel compelled to trade in these securities, I suggest writing out of the money puts to get long exposure and generate a return on whatever idle cash you don't care to convert directly into metal. I won't bother.

[Managing Editor]

Thanks for your comment.

Let's, however, clarify, some points.

First, the counterparty for each option transaction on the Chicago Baord Options Exchange, where GLD contracts trade, is the Options Clearing Corporation. Default risk passes from the trader to the OCC once a trade is matched. OCC steps in and become the buyer to every seller and the seller to every buyer, allowing traders to focus on only one counterparty rather that several entities with varying levels of creditworthiness.

Owning physical gold is not without its own set of risks.

First of all, there's the capital commitment. If you buy gold for cash, you tie up a lot of capital in a non-interest-bearing asset. Gold's price volatility makes the risk BIG when you commit MORE capital to the asset. Owning a LEAPS call, on the other, limits the capital exposure (to, in the example cited, less than a third of the value of the underlying asset).

Risk isn't limited to losing interest on your capital, either. There are real expenses attached to holding gold in the form of storage and insurance costs.

Gold's price voilatility, too, creates substantial risk in itself. The more capital commited to the trade, the lareger the risk.

Gold, being denominated in dollars, too, exposes the holder to exchange risk. If you used dollars to buy gold, but had to liquidate in other currency, you port the exchange risk into your transactuion.

Then there are the costs of transfer. Physical gold must be certified or assayed at each transfer, adding time and expense to such actions.

You say "traders in GLD options must surely be gold bears, fools, moneyed types so filled with hubris that they could never imagine their own financial system collapsing, or nihilistic speculators convinced that in extremis even the most dependable form of money will surely be worthless."

The example given in the article illustrated the purchase of a LEAPS call. That's one of the most bullish positions conceivable; more bullish, in fact, than owning the underlying asset outright. What makes this trade bearish?

You also "suggest writing out of the money puts to get long exposure and generate a return on whatever idle cash you don't care to convert directly into metal."

IYou damn a long LEAPS call position -- one that offers open-ended profit potential on gold's upside with a clearily defined and limited risk on the downside -- on the one hand, then advocate the writing of naked puts for a limited profit potential (in fiat dollars) and a large downside.

Had you considered the fact that an assignment on the short puts would put you long GLD shares -- the very same position you'd be in if you exercised the long GLD LEAPS calls?


It seems contradictory to damn a long LEAPS purchase, th If you feel compelled to trade in these securities, I

[mark mchugh]

Somehow, I missed this article. I really like how you broke down the risks and costs and your commentary was extraordinarily clear. I like the strategy. We will probably be stuck with the USD for some time, like it or not, and exchanging physical gold presents it own set of challenges, as you pointed out. Maybe a hybrid strategy (between ETF and physical) is the best way to go.

I am a little curious if you know the tax implications of LEAPS (I don't). If an option position is held for more than one year, does it qualify for the capital gains tax break? Because, according to the IRS, GLD gains are taxed like income, regardless of holding period. Which sucks.

If GLD goes much higher than $100, the LEAPs looks like an even better use of capital.

[Managing Editor]

Mark -

Gains or losses on LEAPS positions, regardless of the underlying asset, are treated as capital assets: a holding period in excess of 12 months entitles a long to a long-term capital gain or loss.

[mark mchugh]

Good to know. Makes an even better argument.
Thanks.