I get calls from clients asking me whether it’s too late to get involved in the gold at these near-record highs. I want to review a strategy I believe can help individual traders level the playing field with the large institutional traders, and allows you to stay in a bullish position even though the market may experience sizeable declines in the short-term. I use Fibonacci levels to help anticipate appropriate entry and exit points on trades, which I have outlined in the chart below.
I think gold should hold $1,790. If it closes underneath, there may be reason for concern. However, if gold remains on a bullish track, which I think it will, you might consider a bullish option strategy. You could buy a November $1,800 gold call, which expires October 26, 2011. The cost is about $9,000 currently for this option, not including commission costs. This position means you have the right, but not the obligation, to be long a gold futures contract at $1,800, if your option is in-the-money at expiration. You might find that an attractive proposition, considering gold is priced above that level currently, and you’d be getting a better price to buy it. If gold moves dramatically lower and your option is out of the money at expiration, the most you can lose is the $9,000 you paid for the option (plus commission costs).
However, at $9,000, you might find that to be a little expensive. In this strategy we want to minimize the upfront cost of an already in the money position. So to help offset that cost, in this specific strategy consider selling out of the money options to help finance the 1800 in-the-money call. In this case, you might consider selling two 1970 calls, a level at which I see as a major resistance point. When you sell options, you collect premium and in this case, you collect $6,700 (not including commission costs). It is important to note that selling calls at 1970 means you may be assigned a short futures position if the price of gold is above $1,970 at expiration. It is important to note that even though you are naked one 1970 call, your breakeven point at expiration comes when gold is trading above $2,140. So, at expiration, if the market is above $2,140, you would be experience a loss as if you were short from that level.
Now to further offset the price of the 1800 call, I suggest selling one 1670 put and bring in an additional credit (premium) of $2,000. The chart illustrates that this is well below major support levels, but remember if the market does trade below this level, you run the risk of being long at any price below $1,670 at the time of expiration.
The calculations then work out as follows. You pay $9,000 in premium for the options you bought, and receive $8,700 for the options sold. The net cost basis would thus be $300, not including commissions and any other trading costs.
This is called a ratio spread. You have a lot of room for the market to move to experience potential profits. And, you will be able to remove some of the emotion out of your trading, because even if the market makes a $30 or $40 move in a day, you will not be stopped out. If you believe the gold market will fall between these levels between now and October 26, 2011, I think this is a compelling bullish strategy. For further explanation at which prices bring in potential profit, and more information about the potential risks, please give me call.
One advantage of doing a spread like this is that the margin requirement is typically less than if you were to engage in a futures position. The margin on this spread is approximately $5,000 – $5,500, while trading a gold futures contact instead would require margin of $9,450. You’ve cut your margin roughly in half. Please be aware, margins are subject to change without notice at any time.
This type of strategy may be a new concept to many of you, but it can work for the right investor, with the understanding of the risks involved. This type of spread can be conducted in any market where you are concerned about volatility. You can weather the ups and downs in the market, knowing you have a wide range before expiration.
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