Trading Gold Options: What to Consider

03/15/2010 10:53 am EST

Focus: OPTIONS

Many traders want to get into the market, but have a difficult time finding the right opportunity to get in at the desired price. If you place a limit order, it might not get hit. And even if you do have a position on, it can get stopped out due to volatility. Even if you are correct in your market view, that doesn’t mean it will always result in profits.

There are a variety of strategies you might not have considered that can help with these problems. Options selling (writing) is one of them. If you are a highly conservative investor, this approach might not be right for you, but I will outline what’s involved, including the risks, using the gold market as an example. This strategy applies to virtually any market.

The gold market has provided tremendous opportunities over the past ten years.  I would argue that it has perhaps been one of the most lucrative of all asset classes for buy and hold investors. In the beginning of the decade (2000), gold was trading under $300 an ounce and was severely depressed for a variety of reasons. Even on an inflation-adjusted basis, gold at about $1,100 an ounce today is still well below what we might expect given the performance of other assets and macroeconomic factors. Gold is in a very long-term structural bull market, and I anticipate this trend to continue.


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Even if you agree with my viewpoint on gold, as a trader, it’s tough to avoid getting too close to the market. Traders watch prices move up and down daily, and often lose sight of the arguments for buying and holding gold. Traders often have the right opinion, but don’t have enough capital to maintain their position though volatile periods and get stopped out as a result. For that reason, in the past few months, I’ve seen some reluctance to actually pull the trigger on a trade and get into this market.

Most traders think about options in terms of buying. They buy calls if they feel the market will go up, or buy puts if they think the market will go down. To buy an option, you pay a premium, and your risk is limited to that price. If the option expires worthless, you are out of the market and move on. One of the problems with this approach is that the vast majority of options expire out of the money and don’t result in any profits for the buyers. The market may do what you expect, but the option premium erodes faster than the market moves in your desired direction. So if the owners of options aren’t making money, who is? The people who are selling them are. If you are bullish on a particular market, you can use options to get into a position more slowly by selling puts.

NEXT: Learn to Sell Puts, Know Key Risks, and More

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Selling Puts

If you sell an option, you collect the premium from the buyer. In exchange, you bear the risk of being forced to either buy or sell the underlying commodity if that option expires in the money. You are assigned a position in the futures market, and your risk profile becomes that of any futures position holder—potentially unlimited. However, if you actually want a position in the market, this can be a viable approach for you. Let’s look at an example of how this strategy works.

Let’s say gold futures are currently trading at $1,123 an ounce and you are bullish, but you’d really like to own it at a lower price, say $1,100. Looking at the available option strikes, you see the May 1100 put is trading at $17.20 to $18.40. At $18, that represents a value of about $1,800 for every 100-ounce gold contract. These options expire on April 27. Please note my examples do not include commission costs, which you will also have to factor in.


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You sell the put and collect $18 for bearing the obligation to potentially own a gold futures contract at $1,100, something you’d like to do anyway. Your average cost is now $18 ($1,800) lower with the option than if you had bought a gold futures contract at $1,100 because you collected premium. You are a bit better off than a futures trader who has a limit order to buy at $1,100, hoping it gets filled. If you hadn’t sold the option and simply tried to buy gold at $1,100, your limit order would not get filled if gold moved quickly up to $1,200. You would’ve missed the run.

With the option, you are still in the game. If instead gold hit $1,100 and you got filled on your futures order, but then the market quickly fell to $1,082, you would need more capital to maintain your position, and might get stopped out. Then you’d have no position and would’ve lost money, even if the market turned up again. In volatile markets, this is a fairly common occurrence.

You can see that if you sell a gold option, you have an extra $18 cushion that the outright futures traders doesn’t have (down to $1,082). If your option expires in the money, you wind up being assigned a position in gold you wanted anyway.

Outcomes

As a seller of options, there are two basic outcomes. The first is that the market climbs away from your strike price and is never assigned. You keep the $1,800 premium you collected and walk away. Perhaps then you try looking for another option to sell and repeat the same exercise.

The other outcome is that the market falls below your strike price, your option is in the money, and you are assigned a long position in gold futures. So you now you own a gold contract with the risks involved for the futures position. You have a few strategies to consider at this stage. If you wish, you can now sell covered calls and collect premium until that position is called away from you. This strategy can be compelling in markets where there is a pretty clear long-term trend. We have helped clients execute this strategy in a number of markets, including Treasury bonds and the Canadian dollar. You can earn some income and get an extra performance boost.

The Risks

Over time, when you buy an option, your premium will decay to zero, and your investment will be worthless. You know the most you can lose as an options buyer—your premium paid. For example, you believe gold will move above to $1,140 in the next month, so you consider purchasing an 1140 May gold call at a cost of approximately $18. You now have until expiration on April 27 for gold to make that move. If you own the $1,140 call, you need gold to rally to $1,158 in that time to break even on this trade, not including your commission costs. That’s a pretty big move, although it’s certainly not impossible. However, you are fighting the clock. Gold can be trading at $1,130 or $1,135 and your option premium has likely decayed to $8 or so.

If you sell an option, as mentioned, the risk is identical to the risk of buying or selling a futures contract at $1,100, minus the premium you collect. If you are happy to buy a futures contract at $1,100, it’s actually less risky to sell the put option instead. If gold went to zero and people were giving it away, you’d lose $1,082 an ounce, that’s your worst-case scenario. If you really want to own gold, feel it is going to the moon and won’t look back, this strategy might not be the most appropriate. Remember, gold has to pull back from current levels for you to be assigned a position at $1,100. You might have heard of a term called a “naked” option. Naked short selling involves selling a put with no desire to own the underlying commodity, or selling a call without already owning it. That’s a fairly aggressive strategy. You have to be willing to actually take the position, and if you don’t, it can bring you grief.

It’s important to know how much risk you are willing to bear, what your potential profits and losses may be, and which contracts can allow you to take advantage of the long-term trend without being wiped out.  Most markets don’t tend to go straight up or down without some corrective moves, so as mentioned, in volatile markets like gold can be, selling options might be worth considering.

By Aaron Fennell of Lind-Waldock

Aaron Fennell is a senior market strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada.

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