Spinning Synthetic Gold

August 26, 2010

How to establish a long gold position—without actually buying gold.            

 

 

According to the Brothers Grimm fairy tale, Rumpelstiltskin could spin straw into gold. Investors can do the same. Not literally, mind you, but one can obtain a long gold position (or a proxy position in gold futures, a gold trust or a mining stock) without actually touching bullion, futures or stock.

It's done through the options market. A so-called synthetic long gold position combines the purchase of a call with the simultaneous short sale of a put, where both options share the same exercise price and expiration date. The position mimics a long gold position's potential risks and rewards.

Now you may well ask why you should undertake something as complex as an option position when you could simply buy gold instead. The answer's simple—it costs less. You can, for example, trim your capital commitment by as much as 93 percent using a synthetic long position. That's the same kind of leverage obtainable in the futures market. In essence, you can trade a futures contract without necessarily having a commodities account.

Let's walk through an example.

As this is written, the SPDR Gold Shares Trust (NYSE Arca: GLD)—our proxy for bullion here—is changing hands at $119.78 a share. Suppose you're bullish, and you think GLD will pop up to $125 within the next month.

You could buy a September $120 call option for $3.12 a share now. That would give you unlimited profit potential over the next 26 days (‘til the option's expiry) if gold prices drag GLD above your breakeven point. At expiration, that would be $123.12, giving you a profit of $1.88 per share if your price objective is reached. That's a 60.2 percent return. Not bad.

 

Problems And Solution

One of the problems with your call, though, is its delta. Delta is one of the "Greek" risk factors priced into every option. Simply put, delta is a coefficient that describes the price sensitivity of a contract.

In this instance, the delta for the $120 September call is .506, or 50.6 percent. That means that today, we can reasonably expect that a $1 increase in GLD's price will be reflected as a 51-cent increase in the call premium. Delta isn't constant; it migrates toward zero over time if an option remains out of the money (for a call, that means the underlying asset's market value remains below the call's exercise price) and towards one when the asset's value exceeds the strike price.

On top of that, you've got to pay $312 for your option contract. The more you pay for a call, the higher your breakeven.

Now, if you sell a GLD September $120 put along with your purchase, you collect a cash premium that defrays the cost of your call. Today, for example, the put could be sold for $3.13 a share, so you'd actually earn a net credit of a buck (a penny a share times 100 shares) for entering the market.

You earn something else as well—the put's delta of .494, or 49.4 percent. Selling a put gives you positive delta, or beneficial sensitivity to a GLD price increase. Add the put's delta to the call's and you end up with a net delta of 1.00, or 100 percent. Thus, every dollar increase in GLD's price will be translated into a matching increase in the paired options' net value. (Of course, the option position will reflect GLD's downside movements as well.)

Now you see why this is called a synthetic long—it mimics the underlying trust's share price movements.

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