Question: How can you play a bullish gold outlook while reducing the risk of an uncertain and volatile marketplace?
Answer: A bull 1x2 call spread.
Athough the presidential election will be settled by the time you read this, there still will be a lot of uncertainty regarding the economy and volatility in the metals sector.
Efforts to discern what the next few weeks or months may hold, while always difficult, have been intensified by the recent uptick in realized volatility. Oscillations are exacerbated by program trading, polling data, central banks, jobs numbers and questions regarding the fiscal cliff.
President and General Dwight D. Eisenhower said: “In preparing for battle, I have always found that plans are useless, but planning is indispensable.”
While we are traders, not soldiers or politicians, Eisenhower’s statement rings true. Absent a plan, you are more likely to fail in whatever you do, so here is some background and a plan for trading metals in the coming weeks.
On Nov. 2, the Bureau of Labor Statistics (BLS) reported that the economy added 171,000 jobs in October, beating expectations by about 40k. The BLS also revised the August and September data considerably higher (50k and 34k respectively). The release caught a fairly directionless short-term metals market flat-footed.
The board was blood red on the number as traders pushed gold lower by $40, 2.35%. Silver sold off by $1.39, 4.3%. The week ended in fairly classic “risk-off” fashion with the U.S. dollar and the VIX higher, and just about the entire commodity complex closing at or near multi-week lows.
The weakness in metals may present attractive entry points as the market nears the end of a healthy correction where outside forces still are very supportive of higher prices.
While the election is days away as of press time, the results will not change the overall outlook that higher prices are likely into the end of the year.
Technically, February gold is just north of its 200-day simple moving average. February gold closed $1,677.30 on Oct. 2 with the 200-day simple moving average at $1,672.80. The 200-day may provide some support, but there also is support at $1,650 and $1,600 (see “Firewalls in place”).
General uncertainty and market volatility lend to near-term options strategies, so we will consider January options (governed by February futures), which expire on Dec. 26. We would execute a ratio spread by going long a January 1X2 call spread; buy 1 January gold 1700 call at $26 and sell 2 January gold 1750 calls at $12 for a net debit on the ratio of $2, or $200 plus commission, which makes the downside risk a fairly small $200 plus fees and commissions.
Ideally, gold futures move toward your short strike (1750) at expiration, in which case the position has a maximum potential value of $50 less your $2 debit or $4,800. Again, this position is net short one unit, so there is unlimited upside risk. Your breakeven on the upside at expiration is $1,798, above which the position has unlimited risk. (You could purchase the January 1800 call and turn the position into a long butterfly – defined risk, at any point).
As a ratio, the initial margin is $4,150 and $3,100 to maintain. The delta on the ratio call spread is flat at inception, but it bleeds into a long delta as time passes, depending on price.
If you are more bullish and more aggressive, you may consider buying the outright February gold futures at $1,675 and sell 2 January 1750 calls at $12 each. You collect $24 ($2,400) in option premium (excluding frictional costs). Expiration breakeven on the downside is $1,651. The ideal scenario would have gold move back toward $1,750 at expiration, in which case the position has a maximum potential value of $9,900 less commission. The position is net short one unit, so your upside breakeven at expiration comes in just below $1,850.
The position is long 50 delta at inception, so in theory you would be long one half of a futures. The initial margin is $8,500 and $6,250 in maintenance. However, this position has unlimited risk outside of breakevens.
Traders who are bullish but believe the correction has more legs and prefer a passive approach may consider selling outright puts at a level they would be comfortable owning gold futures. For example, a short January 1600 put would collect $1,500 in premium less commission; the 1575 would bring in $900.
Whichever scenario suits your outlook, it is important to establish a plan and trade your plan. Expect volatility. Make it your friend.
Kevin Davitt is a global execution and futures/options broker at RCM Asset Management and a former CBOE and PHLX options market maker. He also has been a proprietary trader in the energies, metals, grains and index sectors. You can reach him at firstname.lastname@example.org.