Options Strategy for Gold

Is it still a good time to buy gold? Buying gold options may be a safer bet. Here’s a strategy for you to consider…

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.

See seekingalpha.com for entire strategy

Option Trading Secrets