GOLD OPTIONS: BUYING PUTS
Let's say that you believe gold is overbought - a consequence of a safe-haven buying that can quickly
unwind. Not wanting to guess the top, you first wait for technical weakness
in price that will provide the signal to short the market at which point you'll look to buy a gold put option.
By late October, this has happened. (See chart at right.)
The first step of the
purchase decision
is to determine the maturity of the put option: it must be long enough to capture the anticipated price drop.
The December 2009 gold put options expire in
one month and
you feel that's sufficient. The second step is determining the strike price.
December gold put options are available across a wide range of strike prices, each having a different cost.
(See table at right.)
Reading Gold Option Prices
Gold options are priced in dollars (up to two decimals) per troy ounce. One gold option can be exercised into one
gold futures contract and since each contract is based on 100 ounces of gold, the option price must be
multiplied by 100 to get a corresponding dollar value and every dollar change in the price of the option or the underlying
futures for that matter is worth $100 per contract.
For example, the December gold put option struck at 1035 settled at 20.40 meaning $20.40 per ounce. The dollar value
of this option is $20.40 x 100 = $2,040. This put option is at-the-money
since the December futures contract settled the day at $1,035.4 per ounce. Notice that the futures closed
lower over the day by $7.4 per ounce pushing all put option prices higher but that the option prices moved by less
than this amount. In fact, this at-the-money put option rose by just $4.00 per ounce.
As is evident in the table, as the strike price of a put option is raised,
its price increases
as does its sensitivity
to movements in the price of the underlying futures.
Choosing the Strike Price
This requires balancing risk with potential return. The former is simply the cost or purchase price of the option
along with brokerage commission and other trading fees. For example, if you want to risk at most no more than $1,000
on a December gold put option, then only those options having a strike price of 1005 or lower would be acceptable.
The potential return is based upon your expectation of how far gold prices will rally. A useful reference is the
break-even price.
The break-even price of a put option
is calculated by subtracting the option cost and paid trading fees from the strike price.
Consider, for example, the December gold put option struck at 1020. If it is purchased at the settlement price shown, then the break-even
price of the December futures at option expiration is calculated as:
1020 - 13.70 - fee value = 1006.3 - fee value.
At option expiration, December gold futures must be below this break-even price in order to
profit on the option trade.
So, you will only consider put options that have a break-even price above the price to which you expect
gold will fall. For example, let's say that you do not expect the December futures to fall much below $980 per ounce by option expiration which is
the area of last support on the chart above.
Based on this, you would only consider buying put options having a strike price of 990 or higher since otherwise the break-even price
is too low.
What remains is the range of acceptable options. In this case, for an investment of at most $1,000 and with an expectation that December
gold will fall to at most $980 per ounce by option expiration, the put options having a strike price within the range of 990 to 1005
would be acceptable to purchase.
After the purchase, you will need to manage the option position.
What if there are no remaining options that are acceptable after considering your desired risk and price expectation? Then you
can consider buying a more expensive put option and manage the risk, or
you can consider buying a bear put spread.
Bear Put Spread
When buying a bear put spread, both strike prices should be above the price to which
you anticipate the futures will fall by the time the options expire, in this case, $980 per ounce. Based on this, there are several spreads
that can be purchased. For example, the 1000/1010 bear put spread has a value of 10.10 - 7.30 = 2.80 = $280 plus commission and fees.
If December gold futures is below $1,000 per ounce at the time of option expiration, then this spread will close
at its maximum value of $1,000 (calculated as $10 per ounce x 100 ounces). If gold is above $1,010 per ounce, then this spread will expire worthless.
Stepping up the strike prices will increase marginally the cost of the spread, but the chance of the maximum value
being earned is greater since gold need not fall so far. For example, the 1010/1020 bear put spread has a value
of 13.70 - 10.10 = 3.60 = $360 plus commission and fees. Gold need only fall below $1,010 per ounce at the time of option expiration
to earn the $1,000 maximum value of the spread. If gold is above $1,020 per ounce, then this spread will expire worthless.
As you can see, spreads can be constructed at relatively little expense. You can risk more on a spread in return for greater
potential payout by increasing the gap between the two strike prices. For example, the 1000/1020
bear put spread has a value of 13.70 - 7.30 = 6.40 = $640 plus commission and fees but the maximum value is $2,000
and will be earned if December gold futures is below $1,000 per ounce at the time of option expiration.
Because the market for option spreads is generally less active than the market for individual options,
you will likely have to pay a slightly higher price in order to effect the purchase. After the purchase,
you will need to manage the option spread position.
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