Go Bullish On Gold Using Options
Uncertainty is creeping back into the markets which means that the safe-haven commodity is coming back to life. By using the options trade shared in this article, you can profit big from just a small move north in the price of gold.
Ever since central banks started accumulating gold (after the Financial Crisis of 2008-2009), it has given the precious metal an even more important role in investing. Gold has essentially become the de facto safe-haven investment whenever investors become concerned with the financial markets.
In fact, gold has become more than a simple hedge against inflation. Even with interest rates rising (typically considered to be a bullish catalyst to the dollar), gold has not lost any value. Quite the contrary, gold prices are basically back up to pre-election levels.
As you can see from the chart below, the price of the yellow metal plunged after the election (as the stock market soared). Now as the euphoria of having a pro-business administration has leveled off, gold is back to around $1,250 an ounce.
So if gold isn’t just a hedge against inflation – something clearly not a concern in the US right now – then what is it? Why the recent increase in price?
A more accurate description of gold in this day and age is a hedge against uncertainty. Now, uncertainty can take many forms: currency uncertainty, political uncertainty, credit risk uncertainty, etc. The underlying idea is that if you own gold, you have some protection against the unpredictable.
In 2011, when gold climbed above $1,900 per ounce, the entire world was awash with uncertainty. The financial crisis had destroyed banks, debt markets, real estate, and much more. We’re nowhere near that sort of environment now, but gold is well off its yearly lows.
So what gives?
As I mentioned before, the reality of the new administration is setting in. As pro-business as the new group is, it’s not going to be easy to roll back tax laws or implement massive spending increases on infrastructure. Perhaps more importantly, recent charges of espionage and other shady activities could hamstring key members of the administration even further.
Whatever your political or economic beliefs are, there is certainly a non-trivial amount of uncertainty creeping into the markets. Throw in a key French election and Brexit talks, and there’s even more opportunity for surprise.
So is it time to load up on gold? Not necessarily. The precious metal has had a nice run, and the sky isn’t exactly falling either. Nevertheless, a savvy options trade may just be exactly what the uncertainty doctor ordered.
The easiest way to trade options on gold is by using SPDR Gold Shares ETF (NYSE: GLD). GLD is very liquid and does a good job of tracking the actual price of gold bullion.
If gold does rally, it looks like the next key range for GLD is around $126-$128. We could use $128 as our upper bound and make it the short strike in a call spread. For the long component, $120 seems like the level the ETF will have to break through to make a run higher.
That gives us a 120-128 call spread as a potential upside gold trade. If we look a couple months down the road, the May 120-128 call spread in GLD costs $1.50 ($1.90 120 call – $0.40 128 call). For $1.50 per spread, that’s a reasonably cheap two-month bet on a gold rally.
If we spend $1.50 on the spread, $150 per spread becomes our max loss. Max gain is $650 per spread ($8 wide gap – $1.50 cost x 100). It’s over a 4 to 1 payout on the cost of the spread, which is nice upside. The chances GLD rallies above $128 by May are very low, so selling the strike is a good way to reduce costs.
If you feel GLD has a lower ceiling, you can also use a lower short call strike. The 126 call is only trading for $0.60 though, so you’re not saving much by moving down a couple strikes – and you’ll reduce your upside potential by $200 per spread (2 points on the spread gap).
With uncertainty spreading over both domestic and international politics, it may be a good time to take an upside position on gold. Using a call spread on GLD can significantly reduce the cost of being bullish on gold, while still providing strong upside potential.
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Category: Options Trading
