How To Straddle The Gold Market

April 01, 2010

Don't pass up a golden opportunity to play cheap volatility premiums in everyone's favorite precious metal.
  • Why gold's caught in a tug of war
  • Why strangles and straddles work in range-bound markets
  • Running the numbers on a gold strangle


In case you haven't noticed, there's a real tug and pull going on in the gold market. Bulls want higher prices, while bears want to take the market down, but neither camp is in command. Oh, there's an occasional blip in one direction or another, but prices remain bound by the top made in early December and a reactionary low that followed two months later.

The market's trading range is reflected in spot metal prices, in COMEX gold futures and in the price of SPDR Gold Trust Shares (NYSE Arca: GLD), which topped out at $119.54 on Dec. 4 then ratcheted down to $102.28 on Feb. 5.

The pattern now being scribed by gold and gold proxy prices is similar to the cyclical waylay between $55 and $72 in 2006-07, as well as another in 2008-09 when prices bounced between $70 and $100. Ultimately, prices broke out on the upside following these two consolidation periods.

The question that now puzzles investors is whether gold prices (and by extension, GLD prices) are likely to follow suit and break to the upside again, or, this time, fall precipitously.

It's the toppiness in the gold positions held by money managers that's got investors worried about the downside. Essentially, they figure the managed money pool is already saturated with gold, leaving little potential buying power for the future.


Money Manager Strength In Gold Futures

Money Manager Strength In Gold Futures


Balancing that point of view is a pervasive fear of future inflation and currency degradation wrought by record deficit spending.

So what's an investor to do? Well, you can certainly sit tight and wait. But if you do, you'd be passing up an opportunity the market doesn't hand out every day—cheap volatility premiums.

Option traders know all about volatility: It's one of the primary drivers of option costs. When volatility contracts, as tends to happen in range-bound markets, option prices soften. So much so, in fact, that the purchase of option straddles and strangles becomes attractive.

A straddle is a combination of a put and a call on the same asset, each sharing the same expiration date and exercise price. A strangle is similar, but the options' strike prices are different.

A quick reminder: A call bestows upon its purchaser the right, but not the obligation, to purchase a contract's underlying asset at the stated exercise price anytime before the option's expiration date. In lieu of exercise, the option can be sold for its market price. A put, on the other hand, grants its owner the right to sell the underlying asset at the strike price, or to sell the option itself, before expiry.

Volatilitywise, GLD options are the cheapest they've been in two years. With GLD at the $109 level now, out-of-the-money June options, for example, are priced with an implied volatility of 18.5 to 18.8 percent. Reflecting the present market quietude, a June call with a $119 strike price is worth just 79 cents a share (since an option contract covers 100 shares, the contract's total cost is $79). If GLD's market volatility was at 25 percent, closer to its long-term norm, the option—all else held constant—would likely sell for $1.81 a share.

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