From the March 2014 issue of Futures Magazine • Subscribe!

Reduce or eliminate downside risk

A carefully crafted options position that is short to flat overall premium (easily achievable when trading longer dated instruments) and long extra short dated calls (typically inexpensive) can deliver a safer, more desirable ‘insurance-like’ gold investment. For example, if you buy a six-month 1x2 call spread you can collect a decent amount of premium. This leaves you long one lower strike call, and short two higher strike calls. Because you have collected premium you will profit if gold fails to rally. Of course there is unbound risk whenever you are net short calls (like here, long one and short two).  Pairing this spread with the purchase of two 30-day calls (much less expensive due to their short tenor) mitigates this risk. In fact, it leaves you long net calls (long one, short two, long two).  Now it’s the best of both worlds — collecting premium and long nets.  Now the position has to be managed. You have to ‘roll’ the front month calls back (five times) until the original 1x2 gets closed off. If you monitor the market closely, take advantage of moves in volatility and skew, you constantly can carry a position that is short premium (but getting less short over time) so it has an agnostic downside, and is always long an extra call. This way you are hoping for the same thing that passive long gold investors are hoping for — to wake up and have gold be hundreds higher. In fact, if it happens, you will likely make more than they do. But the real benefit may be the fact that you can avoid the pain of what happened in 2013 when gold was down 28%. 

You do face risks they do not. Losses are possible due to expensive front-month purchases, market illiquidity, unfavorable volatility and skew conditions. It does, however, present an entirely different type of gold exposure, one that differs in important ways when compared to passive long investment (see “Gold profit and loss,” below).

The P&L graph highlights what can be achieved with a carefully constructed options position — a modest absolute return emphasis when gold moves little, where both small gains and losses are possible, matched with clearly defined desirable performances when gold moves a lot.  Mandates of capital preservation and tail risk payout potential can elevate the efficacy of gold exposure. Consider how valuable a gold strategy that didn’t suffer losses in 2013 could be. Are you investing in gold because you think it is going higher in the next 12 months or does it represent a desire to mitigate other losses at some indeterminate time in the future?

Passive long gold investment can lead to severe losses (more than an insurance asset should) and fail to deliver sufficient protection when needed. If an insurance-like payoff is desired, invest in a vehicle that has the potential to deliver such a return in amounts of 10x, not 10%.  

This strategy runs the risk of underperforming if gold just drifts higher. It is designed to do two things — outperform if gold moves very dramatically, and avoid the frustrating stop-out that often eliminates positions that eventually would have been profitable. It does not rely on market timing.  It is designed to always keep your chip on the table.

Using options can be the best way to maintain upside gold exposure while mitigating downside risk.

Paul Sacks, CIO at Aurum Options Strategies LLC, manages money for investors interested in unique gold exposure. He is always up for sharing ideas about trading and the gold market. You can email him at

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