Managing gold volatility with option spreads

By James Ramelli

Spot gold and gold futures markets have been thrown into disarray following Ben Bernanke’s appearance at Wednesday’s Federal Reserve Q&A session. Gold and gold derivatives prices were maintained by the central bank’s stimulus program, as many investors see the precious metal and its counterparts as being the most effective possible inflationary hedges. In the market conditions that the Federal Reserve’s implied intentions would generate, inflation would no longer be a pressing concern, and demand for gold as a protective instrument would theoretically unwind.

Price action in gold has followed a trend that an adherent to the aforementioned belief system would expect; spot and futures markets have both tumbled as far as 7% following the announcement. This trend has, however, been interrupted by Chinese buyers this morning, who paired with Indian markets were able to pull gold out of its most recent slump during April of this year. The efforts of these and other overnight buyers the world over lifted the price of spot gold by 1.51%, and August gold futures were boosted by 0.80%.  This time, however, it doesn’t appear that demand from China or India, the latter of which having been hobbled by government controls on imported gold, will be enough to save the value of gold. To compare, bullion futures slid down 6.4% in the day’s trading in New York to reach $1,268.70/ounce, the lowest level it has reached since mid-2010. The yellow metal will likely show further downward action in the near term, as a significant round number has been broken in $1,300 and fearful gold hoarders are pressured into selling off their deteriorating fortunes.

So how can a trader speculate on movements in the gold markets?

1. Trade physical gold. Although this would offer the best exposure to the price of gold it is extremely capital intensive.
2. Trade the ETF’s. There are several ETF products to choose from that offer exposure to the spot price of gold and double and triple ETF’s can offer some leverage to investors. However, all ETF’s have expense ratios built in so they can never track their underlying 100%.
3. Gold futures and options. Using gold futures and options offers the inherent leverage and capital efficiency that make them an attractive alternative to physical gold or ETFs. Using futures and options is the most efficient way to speculate on gold in the short term.

If we want to take a trade in gold we first must calculate upside and downside targets. With August gold futures trading around $1,295.00 we can use the August 1295 straddle to derive targets. With the straddle trading at $76.00 this implies an upward or downward move of $76.00 by August expiration. This gives us an upside target of $1,371.00 and a downside target of $1,219.00. We can now use these targets to set up a bullish or bearish strategy.

Bearish Strategy

Trade: Buying the /GC Aug 1240-1220 Put Spread for $5.00
Risk: $500 per 1 lot
Reward: $1,500 per 1 lot
Breakeven: $1,235.00

This trade sets up for a 3-to-1 return on invested capital if gold futures trade below the downside target on expiration.

Click to enlarge.

Bullish Strategy

Trade: Buying the /GC Aug. 1350-1370 Call Spread for $4.90
Risk: $490 per 1 lot
Reward: $1,510 per 1 lot
Breakeven: $1,354.90

This trade also sets up for a better than 3-to-1 return on invested capital if gold futures trade above the August upside target on expiration.

With increased volatility in gold markets after the Fed announcement, it is especially important for traders to look for setups with good reward-to-risk ratios.

Click to enlarge.

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