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A Bullish Option Strategy for Gold

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It's not just the metal in demand, but the options that confer the right to buy it.

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I'll stick with you baby for a thousand year
Wish upon wish, day upon day, oh Lord I believe all the way.
Nothing's gonna touch you in these golden years… gold whop whop whop
But one of these days, and it won't be long, gonna drive back down to where you belong

-- David Bowie, "Golden Years"

We all know the story behind gold: First it was inflation fears, and now we have the supposed fundamentals that central banks continue to swap out of paper that gold is worth north of $15,000 an ounce on a currency basis. There have been multiple gaps higher in the past month and there's no reason to think this trend will end anytime soon.

With the precious metal hitting another new high of $1,180 an ounce on news that India might be back buying billions of bullion, maybe it's time I chime in and put an end to this rally by suggesting a bullish option strategy.

Demand Market


It's not just the actual metal that's in demand -- so are the options that confer the right to buy it. As Professor Warner notes in The Gold ETF Seeing a Volatility Explosion, the implied volatility for the SPDR Gold Shares (GLD) has been moving up at steady clip, gaining some 12% to 22 over the past two weeks, and now stands nearly 45% or 7 percentage points above the ETF's 20-day historical or realized volatility.

There was a similar increase in implied volatility relative to realized during mid-January to mid-February when GLD shares climbed some 25% from around $79 to $99 during a five-week period, and gold first touched $1,000 an ounce.

This option-price behavior is unusual in two ways: Typically, you don't get that type of divergence in which premium of IV over HV increases unless there's some upcoming event such earnings or pending news. It's unlikely gold is going to miss earnings, merge with silver, or receive approval to treat cancer.

Also, IV often declines or simply holds steady when a stock is rising. However the tech bubble showed that IV can indeed shoot higher when you have prices gapping higher as investors scrambled to buy out-of the-money calls. And that's likely what's at work here.

Scared of Heights


That is, the demand for upside exposure is pumping up option premiums. This actually would be consistent with the pricing skew that's exhibited in commodity options. Markets such as oil and gold, which have a limited supply, are driven by demand. And the greater danger or fear -- at least by end users or those with a true economic exposure -- is of higher prices. Stocks, on the other hand, are supply-driven; a company can always issue more shares, and the fear is of price declines. In the stock market, aside from short-sellers, no one gets hurt from a rising share price.

Option prices in commodities tend to be driven by the demand for calls as users need protection from higher prices, while in stocks, it's the demand for downside puts protection.

Given that GLD is something of a hybrid between stock and commodity, some of the demand component might be influencing the price behavior of its options.

But I digress. The real question is whether there's a way to take advantage of what seems a tendency for implied volatility to trend higher as the price of the underlying does likewise.

Spread 'Em


Again, using the tech bubble as a precedent, it would seem the safest approach would be to use spreads -- that is, the simultaneous purchase and sale of similar option contracts but with different strike prices to both minimize and capitalize the changes in volatility, or vega exposure. A back spread is a strategy that benefits from both a large change in price and an increase in implied volatility. A back spread is constructed by selling short an in-the-money option and purchasing a greater number of out-of-the-money options.

With GLD currently trading around $115.60, one can sell the January $113 call for $5.30 and buy the $117 call for $2.70 a contract. So if you sold one $113 call and bought two $118 calls, it would cost only a $0.10 net debit for each 1x2 back spread. If the price of gold drops back below $113, the maximum you can lose is that $0.10.

The position starts with a positive delta of 0.22. The delta will increase, meaning the position will get longer and be more profitable, as the price of GLD rises. Also, if the theory holds true, the position will have the added benefit of an increase in implied volatility along with the increase in price.

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No positions in stocks mentioned.

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