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

Buying a vertical bull call spread

The international financial meltdown during the last quarter of 2008 brought about a major deflationary spiral. The credit markets locked up and the Federal Reserve was compelled to inject liquidity into the system. Under normal circumstances, printing a trillion dollars would lead to inflation. The money that the Fed injected into the economy staved off further deflation but it did not immediately mean a 180 degree turn into an inflationary environment.

The velocity of money still has not returned to its normal rate. Any sign of economic recovery causes inflationary fears to be stoked. The last great bout of inflation in the U.S. occurred in the late 1970s and early 1980s, though inflation was well above target level prior to the current recession. The price of oil was skyrocketing and the Fed monetized the increase in the price of oil to lessen the burden in the U.S. economy. When there is a greater amount of any commodity, its scarcity, and therefore its value, declines. Gold and silver prices headed straight up as a result of the weakened currency.

Gold and silver traditionally have been the home for those investors fleeing their own debased currency. After World War II, the major industrial countries signed onto the Bretton Woods Agreement. This agreement created fixed exchange rates among the major currencies, which were all backed by gold. Each currency could be exchanged for a specific amount of gold. Since the Nixon administration removed the United States from the gold standard in 1971, floating exchange rates have determined the relative worth of one currency vs. another. There still remains a strong psychological tie between gold and monetary stability.

In the last five years the price of gold has more than doubled. In 2005, gold was trading near $400 per ounce and finished above $500 by the year end. In April of 2006, gold rose above $600. In May it traded above $700, and then hovered around $600 for the balance of 2006. Gold headed up again in 2007, as the precious metal traded above $800. The trend continued in 2008, as gold traded above $1,000, before backtracking to under $900. In November, gold surpassed $1,100.

The historical inflation-adjusted high for gold is $2,300 per ounce. That occurred in 1980, when the aforementioned oil bubble took place. Based upon that number, it would seem that gold still has plenty of room on the upside.

Over the past three months, oil has risen at a higher rate than gold. Has gold already had its run? No one knows for sure but even if you hold a strong gold bias, there have been numerous corrections during this multi-year gold rally that knocked out longs before they could profit from the move (see “Timing is everything”).

What does the investor do when it appears that there will be a breakout in gold? The investor can buy actual gold bars and coins but there is no downside protection and no leverage with the purchase of the physical commodity. In addition, there is the hassle of storage problems. Gold futures are the best way to gain leveraged exposure but are volatile. The April gold futures were trading at $1098.10 an ounce on Nov. 6, 2009. Each contract is one hundred ounces. That’s $109,810 per contract. The investor can lay out as little as $6,100 per contract. If the purchase goes against the investor there will be repeated margin calls even on a couple percentage point move.

Another method would be to purchase call options on gold futures. The April 1120 calls on gold futures are offered at $52. That’s $5,200 per contract. Purchasing that call gives the investor the right to own the April gold futures contract at $1120 an ounce and limits his downside. The investor can cut their purchase price by more than half by selling the April 1240 calls at $26.90, executing a vertical bull call spread. That means that the investor stops making money above 1240. The spread price is $25.10 ($2,510). Looking at the highlighted area of the chart, an investor who got long gold with this approach would have had the wherewithal to wait out the drawdown and profit from the long position.

Dan Keegan is an options instructor and head options mentor at www.TheChicagoSchoolofTrading.com

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