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OPTIONS TRADING STRATEGIES
BUYING GOLD CALL OPTIONS
Let's say that you are bullish on gold but have been waiting for a minor sell-off in order to
get long this market at a favorable price. By late October, this has happened. (See chart at right.)
You expect that gold will soon recover and break to new highs and wish to buy a gold call option.
The first step of the
purchase decision
is to determine the maturity of the call option: it must be long enough to capture the anticipated price rally.
The December 2009 gold call options expire in
one month and
you feel that's sufficient. The second step is determining the strike price.
December gold call 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 call option struck at 1035 settled at 20.80 meaning $20.80 per ounce. The dollar value
of this option is $20.80 x 100 = $2,080. This call 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 taking all call option prices lower as well but that the option prices moved by less
than this amount. In fact, this at-the-money call option fell by just $3.40 per ounce.
As is evident in the table, as the strike price of a call option is raised,
its price declines
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 call option, then only those options having a strike price of 1070 or higher 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 call option
is calculated by adding the option cost and paid trading fees to the strike price.
Consider, for example, the December gold call option struck at 1050. If it is purchased at the settlement price shown, then the break-even
price of the December futures at option expiration is calculated as:
1050 + 14.80 + fee value = 1064.8 + fee value.
At option expiration, December gold futures must be above this break-even price in order to
profit on the option trade.
So, you will only consider call options that have a break-even price below the price to which you expect
gold will rally. For example, let's say that you do not expect the December futures to rally much above $1,090 per ounce by option expiration.
Based on this, you would only consider buying call options having a strike price of 1080 or lower since otherwise the break-even price
is too high.
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 rally to at most $1090 per ounce by option expiration, the call options having a strike price within the range of 1070 to 1080
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 call option and manage the risk, or
you can consider buying a bull call spread.
Bull Call Spread
When buying a bull call spread, both strike prices should be below the price to which
you anticipate the futures will rise by the time the options expire, in this case, $1,090 per ounce. Based on this, there are several spreads
that can be purchased. For example, the 1060/1070 bull call spread has a value of 11.70 - 9.30 = 2.40 = $240 plus commission and fees.
If December gold futures is above $1,070 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 below $1,060 per ounce, then this spread will expire worthless.
Stepping down 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 rise so far. For example, the 1050/1060 bull call spread has a value
of 14.80 - 11.70 = 3.10 = $310 plus commission and fees. Gold need only be above $1,060 per ounce at the time of option expiration
to earn the $1,000 maximum value of the spread. If gold is below $1,050 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 1050/1070
bull call spread has a value of 14.80 - 9.30 = 5.50 = $550 plus commission and fees but the maximum value is $2,000
and will be earned if December gold futures is above $1,070 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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December 2009 Gold Futures
Settle as of Oct 27, 2009: $1,035.4 Change: -7.4
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December 2009 Gold Call Option Prices
Prices as of Oct 27, 2009. Source: NYMEX
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