In case you didn’t hear the good news, the recession is over. The official announcement came in mid-September. Yes, indeed, it ended last year. So we can all quit our belly aching and get back to what we were doing.
Regardless, many high net worth investors are not feeling the love. Bad enough are impending tax hikes and suffering practices and businesses, but throw in that most asset-based investments (other than gold) have been lackluster at best, and you have a class of investors that is probably not yet ready to rejoice in the "slow but steady" growth.
Many investors say that because their stocks, real estate and other assets are performing poorly, an option-writing portfolio would have to suffer the same fate. Those investors would be wrong.
As an option writer, you have the ability to adapt your portfolio to any market or economic condition — bullish or bearish. Do it right and you will not only beat your other investments with this strategy, but you can thrive in an otherwise unfriendly economic climate.
The economy, Fed & commodities
New commodity investors need to grasp the importance of knowing the fundamentals of each commodity they are trading. Supply and demand play a major role in dictating price direction of any commodity such as crude oil, corn or silver. There are far fewer factors to consider when analyzing a commodity than there are when analyzing a stock. That’s one reason you may chose to sell commodity options vs. individual equity or equity index options.
While fundamentals are unquestionably important in commodities, there are times when macroeconomic conditions take center stage and must be given their due weight. Late 2010 appears to be one of those times.
The economic "recovery" is not happening as quickly as many would like, and there is the real fear that a double dip recession could occur. Even optimistic forecasts have the U.S. economy growing at only 2.5% to 3.0% next year. This has the Fed leaving the window open for further quantitative easing, which is Fed lingo for "we’re going to expand the money supply." All this in an effort to further stimulate the economy (further lower mortgage rates) and at the same time stave off deflation.
The Fed has pretty much announced another round of quantitative easing, QE2 as it has come to be called. The only question is how much and how open they will leave the window for more intervention. It has torpedoed the dollar and further spurred gold prices to new record highs. There has been some "buy the rumor sell the fact" action in mid-October, though, when it became a certainty involving both the dollar and gold, which are normally negatively correlated.
Despite the October correction, as long as the specter of quantitative easing looms, upside action in the U.S. dollar will most likely remain limited. And a weaker dollar is often a supportive factor to commodities.
Traders must be careful, however, not to position a full option selling portfolio based on one factor. A weaker dollar does not always mean a bull market in all commodities. Individual fundamentals of a commodity can offset or even trump the value of a weaker dollar. Each must continue to be judged on its own merits. For instance, a weaker economy could mean less demand for certain products, pressuring prices to the downside.
Gold as the exception
Gold, however, is much less subject to supply/demand fundamentals in its price discovery process. Economic factors, along with investor and fund interest, typically drive gold prices. Hedge fund guru George Soros may be right that gold is a bubble, but that bubble might not burst for years. Yes, it’s overbought. Yes, it has a huge speculative position making it vulnerable to corrections. But the Fed’s openness to quantitative easing should keep most of them from running to the doors for the time being.
There are many ways to play the gold market right now, and one path certainly is to sell call options simply because they are available so far out of the money.
While that is a viable strategy, new futures option sellers who believe the value of the dollar will continue to decline through early 2011 can enter a simple trade and feel good about it. They can sell gold puts. For dollar bears, this is as pure of a play as it gets (see "Putting it to gold," below).
The trade: An investor who is neutral to bullish gold prices sells an April gold put option with a strike price of $975. Upon doing this, he receives a premium from a buyer on the other side of the market. In this example, we will assume he collects a premium of $500.
Condition for profit: As long as gold futures prices are anywhere above $975 per ounce (the strike price) when this option expires in April, the investor keeps the $500 as profit.
Cost: There is no cost, per se, as the trader is not buying anything. However, he must put up a deposit to hold this option until it expires. In futures language, this deposit is called a margin requirement. In this case, the margin requirement to hold the trade is about $1,000.
Potential risk: The risk is that April gold futures fall below $975 per ounce (the strike price), in which case the trader could incur a loss. However, he can exit this option at any time prior to expiration.
Selling gold puts is not designed to hit a financial home run in case gold prices soar. However, it can be a reliable, high-percentage play that makes modest but steady profits over time. And gold is not merely a dollar/commodity/currency play. In times of political and geopolitical uncertainty, gold typically performs well. Both the specter of inflation and deflation can be supportive for gold. One reason gold has been strong is the ongoing financial crisis in which we find ourselves. If and when the economy improves, the specter of much higher inflation because of all of the Fed intervention comes into play, which is also positive for gold.
That’s why selling deep out-of-the-money gold puts seems to makes sense. You’re not going to hit the highs or the lows on the head. But get the long-term direction right (or at least don’t get it too wrong), and you can do well. Even in the case of a significant correction in gold prices, this strike sits far enough below the market to remain out of the money.
It’s one way to beat the bad economy blues.
James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing exclusively in selling commodity options. Michael Gross is an analyst with Liberty Trading Group/OptionSellers.com. They are the authors of "The Complete Guide to Option Selling," 2nd Edition (McGraw-Hill 2009).