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).