From the October 01, 2009 issue of Futures Magazine • Subscribe!

Strangling money out of metals

Considering the choppy and volatile metals markets that we are experiencing now — and will probably experience for the foreseeable future — it can be tough to gauge which way the market is going.

Yes, you must take the fundamentals seriously, but, unfortunately, fundamentals have been turned upside down in recent years. Many fundamentally bad investments have gone up and many fundamentally good investments have gone down, and it could make any logical market observer start to question his or her sanity. This is particularly true of precious metals that are used to manage inflation. If recent injections of capital to handle this historic recession brought on by the credit crisis work, we can expect a sharp increase in inflation. If they don’t work and assets continue to decline, metals would be just as volatile.

This doesn’t mean that fundamentals don’t matter. Fundamentals ultimately win, but it appears to be taking a longer time period for supply and demand to play out. Meanwhile, technical considerations tend to be more advantageous in the short-term. Given that, what can a rational metals trader do in the short term?

GOING NEUTRAL

Today’s crazy and volatile market gives us the opportunity to practice a simple strategy called the long strangle. The long strangle is a market-neutral strategy in that it doesn’t matter which way the price of the underlying commodity moves. Whether it gets more expensive or cheaper is irrelevant; all you want it to do is move far and move fast. The more volatile and extreme the move, the better (see “Volatile times”).

The long strangle is a less expensive version of the long straddle. For the novice trader, the long straddle is simply buying a call option and a put option simultaneously in the same market and at the same strike price. Say gold is priced at $950 and you wanted to do a long straddle. You would buy a call option with the strike price of $950 and a put option with the strike price of $950. Both the call and the put would have the same expiration date. In the case of a long straddle, both the call and the put are said to be at the money (ATM) because the strike price and the market price of the underlying commodity are the same. Because buying both a call and a put at the money can be expensive, a long straddle can be a pricey combination.

As any increase or decrease in the value of the underlying would reward one position, while adversely affecting the other, this is not a directional play. Instead you are betting on an increase in volatility. The higher the volatility, the higher the premium will be for each option, particularly the out-of-the-money option.

A long strangle has the same concept only it’s cheaper because both the call and the put are bought out of the money. In either the straddle or the strangle, the strategy is the same; the buyer is hoping to make a large enough profit on one of the legs of the straddle (or strangle) to offset the total cost of the combination.

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