From the November 01, 2010 issue of Futures Magazine • Subscribe!

Take advantage of expected volatility in gold

Question: How can you take advantage of expected volatility in gold without being burned by it?
Answer: Purchase bull or bear vertical spreads or butterflies to profit from big moves with defined risk.

The U.S. Federal Reserve System has poured hundreds of billions of dollars into the American economy. If the velocity of money reverts to the norm, there undoubtedly will be inflationary expectations. Historically, whenever there is inflation, gold becomes a much sought after commodity. After World War II, the Bretton Woods Agreement established fixed exchange rates among currencies and each currency was backed by a fixed amount of gold. That system was dissolved in 1971 when the Nixon administration withdrew the U.S. dollar and decided to have its value based on a floating exchange rate. Consequently, gold’s monetary influence today is strictly psychological.

Today, everybody is seemingly bullish on gold. Gold already has tripled since early 2005. It crossed the $500 per ounce mark by the end of 2005 and in 2006 briefly crossed the $700 threshold. Gold fever picked up steam in 2007, rising above $800 and crossed the $1,000 barrier in 2008 before it plummeted back to the $700 level. Gold was again back above $1,000 within a year and is currently trading around $1,300. The all-time inflation adjusted high for gold is $2,200 from 1980 in the height of the inflation era. Today, deflation seems to be the biggest worry. However, commodities that work their way down to the consumer level are rising sharply. Investors should acknowledge that inflationary expectations are already baked into the price of gold as its price has exploded over the past four years. Bubbles, however, don’t always follow logical lines of progression, as the tech and housing bubbles showed. The big question, then, is how best to achieve a long position in gold, if that is the desire of the investor.

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There are a number of ways to gain exposure to gold. December futures contracts closed at 1,308.3 on Sept. 28, 2010. The spot price of gold closed at $1,309. One December futures contract costs $130,830. You can purchase that contract on margin for $5,670, leverage of about 25-1. If the trade initially goes against the investor, he will quickly be flushed out, though. A Dec 1,400 call costs $790; a Dec 1,450 call can be sold for $440, so a Dec 1,400-1,450 vertical call spread cost $350, less than half the price of the outright 1,400 call. A 15% upward move in gold futures would result in a profit of $4,650 with risk limited to the $350 investment, a 15-1 profit margin. Profits would be capped at the 1,450 level. If the investor wants to limit their downside risk even further, he can sell another Dec 1,450 call for $440 while purchasing upside protection for $230 (1,500 call), netting $210. Buying the gold Dec 1,400-1,450 call vertical spread while selling the gold Dec 1,450-1,500 call vertical spread is a butterfly. The 1,400 and 1,500 strike prices are the wings of the butterfly. The sweet spot for the spread is 1,450, where the 1,400-1,450 spread has achieved its maximum upside profitability while the 1,500-1,450 spread has achieved its maximum downside profitability.

If the current gold move is nothing more than a bubble, then establishing a bearish position could be wise. Shorting a gold future would be one alternative. Once again, the leverage involved can flush a trader out of his position before it has a chance to profit. Another alternative would be to purchase the gold Dec 1,200 put for 6.90 or $690 and sell the Dec 1,150 put for 3.20 or $320, reducing the cash outlay to $370. The maximum profitability for the spread is achieved at 1,150 or lower. To lower the cost basis for the trade, another Dec 1,150 put can be sold for 3.20 while buying a Dec 1,100 put for 1.80, reducing the cash outlay to 2.30, or $230. The maximum profitability for the 1,150-1,200 vertical put spread is at 1,150 or higher. The sweet spot for this butterfly spread is 1,150, where the long put spread achieves its maximum value while the short put spread is still worthless.

The trader can buy both the 1,200-1,150-1,100 put butterfly spread and the 1,400-1,450-1,500 call butterfly spread for 3.70 or $370. If there is a big movement in either direction, the trader will benefit while having a defined risk should gold suddenly sit in one spot.

Dan Keegan is an instructor with the Chicago School of Trading. Reach him at dan@thechicagoschooloftrading.com.

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