Question:
How do you trade your opinion that a substantial move in either direction in a particular market is imminent?
Answer:
Long straddles or time valued spreads.
During the past six years, the Federal Reserve, headed by Ben Bernanke and now Janet Yellen, has arguably been printing money through various quantitative easing programs. In spite of this, the dollar over the last year has rallied sharply against other currencies, particularly the euro. Recently the European Central Bank, headed by Mario Draghi, has engaged in its own QE program.
Over 2,000 years, gold has acted as an unofficial, and sometimes official, reserve currency. Gold is currently serving in the former capacity, despite the occasional call for the latter. Inflation has been tame, despite all of the money that has been created. Should the velocity of money increase then inflation could explode.
In May 2005 gold traded as low as $421. By August of 2011 it had risen as high as $1,917, a nearly five-fold increase in a little over six years. Gold is trading somewhere near the middle of those respective prices at $1,210. You can almost draw a straight line from five years ago to today. If inflation ignites, the price of gold must go up. If the recent economic gains, although anemic, begin to reverse, there could be another deflationary spiral. This means gold is in a strange situation where a sizable move in either direction is possible. To cover both bases some kind of options strategy is needed.
One strategy would be a long straddle on gold futures. The June 1210 call strike is trading at 19.30 and the puts are trading at 24.00, which makes the cost of the straddle $4,370. This means that the upside breakeven point would be 1253.70. The downside breakeven point would be 1166.70. The maximum loss on this trade is limited to the premium paid, $4,370.
The negative aspect of this trade is the premium decay that occurs on a daily basis. The rate of decay is exponential. Each day the premium decays a little more rapidly than the day before, until the expiration week where it explodes. If gold doesn’t move above or below the two breakeven points, the trade is a big loss. Another way to compensate for the daily decay is to scalp a futures contract against your existing straddle position.
For this to be an effective strategy you would need to be long 10 straddles; a $43,700 commitment as futures rarely move in a straight line. As the market goes up you could sell futures against your options position. Your long calls would protect against an explosion to the upside. If gold retraced, you could buy futures back for a profit. Likewise if the futures headed south, you could buy a futures contract against your options position. When it retraced you could sell the futures out for a profit; your long puts would protect against a sharp tumble to the downside.
Another strategy is the long time value spread. This involves selling options in one expiration cycle against the purchase of options in a further out expiration cycle of the same strike. The sweet spot for this trade is at the strike price when the nearby option is expiring. You want every option that you sell to go out worthless. You want every option that you buy to go to infinity.
If you have a long time value spread on and gold went to infinity, the spread would be zero. Likewise if gold dropped to zero. Let’s look at the GLD (SPPDR ETF) July-June 126 call time value spread established for a 0.35 ($35) debit. Because GLD trades at one-tenth the value of gold, you trade the spread one hundred times for a commitment of $3,500. If GLD is trading at 126 at the June expiration, your long July calls are at their maximum value, while the short, expiring calls still go out worthless. If you are looking to capitalize on a downward movement, you can establish the GLD July-June 106 put time value spread for a 0.38 ($38) debit. Going long the spread 100 times would cost $3,800. If GLD is trading at 106 at June expiration, your long July puts are at their maximum value, while the short, expiring puts still go out worthless. The near term options also decay much more rapidly than the further out options. For $7,300 you have a much more affordable position when you are hoping for volatility.
The beauty of options is they are three-dimensional; you can profit on direction or volatility. Volatility spikes in gold can be so extreme that it’s easy to lose money being right on the direction, but off on timing. Options can be used to better define risk and reward.
Correction: April’s Option Strategy was written by Randall Liss, not James Cordier. Futures regrets the error.