How To Straddle The Gold Market

April 01, 2010

 

Similarly, a $101 put is now trading for 95 cents a share ($95 a contract), but would probably be worth $1.84 with a 25 percent volatility assumption.

 

SPDR Gold Trust

 

Now, let's think about combining the two options into a strangle. Buying both options means spending a total of $180, which is not quite the cost of two GLD shares outright. Your purchase premium determines your worst-case breakeven point. At the end of the options' lives in June, GLD would need either to have risen $1.80 a share above your call's exercise price—that is, to $120.80—or fallen $1.80 below your put's strike to $99.20, in order to generate enough of a sale premium to cover your initial purchase.

Your potential profits are open-ended on moves above your upside breakeven or below your downside breakeven at expiration. Remember, though, that these are your worst-case breakeven points, when all you have to rely upon is the intrinsic value of the option; that is, the degree to which the contracts are in the money.

Before expiration, though, the options have extrinsic value. That's simply the market value for the options' remaining life. Think of it as the opportunity cost for the possibility of going into the money.

Let's suppose, for example, that GLD jumps $5 within 20 days, notching up the options' volatility to 21 percent. Though at $113.95, GLD would still be well short of the strangle's upside breakeven, the combination would likely be worth a combined premium of $2.31 ($2.00 for the call and 31 cents for the put). Overall, you'd be ahead by 51 cents a share, or $51, without reaching either of your expiration breakeven points. At this point, you might want to sell the put, recouping its residual premium and leaving you long a naked call with a new expiration breakeven point of $120.49.

The fact that your expiration breakeven is below your real-time breakeven bespeaks the wasting nature of option premiums. Over time, the extrinsic value—sometimes referred to as time value—erodes, eventually disappearing by expiration. That said, a breakout is worth more to a straddler or strangler when it occurs sooner rather than later.

So what's the risk in all this? The deal-killer is more quietude. If nothing happens to GLD by the third Friday in June—that is, if GLD doesn't move beyond the breakeven points—a loss will be sustained. That loss, however, is limited to the option premium paid at the outset.

With volatility this cheap, all investors have to do now is decide if strangling's worth a $180 risk.

 

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