October Gold is down $4.90 per ounce at $1000.30 this morning as I write. Friday’s price close was virtually right at the breakout line on the longer term weekly chart. These are critical days for gold in the near term. The directional movement indicators are bullish and the ADX line is rising quite nicely. Followers of this letter have three different types of trades on now; a near term outlook, an intermediate term and a longer term trade outlook.
The near term trade is that you should be long one October Gold futures contract from $964.00, short one October Gold ($960 strike) call option from $18.50, and long one October Gold ($930 strike) put option from $17.00. Also, you should be long one October Gold ($1045 strike) call option and short 2 October Gold ($1060 strike) call option from a credit of 50 cents. Option expiration for the October Gold is on Thursday, September 24th, or 13 days from today.
The intermediate trade is that you should be long one December Gold ($1100 strike) call option and short 2 December Gold ($1180 strike) call options from a credit of 50 cents. The December options expire in 70 days.
The longer term trade is that you should be long one February Gold ($1270 strike) call option and short 2 February Gold ($1400 strike) call options from a credit of $1.00.
A word about these RATIO CALL SPREADS that we have on to further educate you on the profit potential and risks.
Let’s look at the ratio call spread that we have on for October Gold. We are long one October Gold ($1045 strike) call option and short 2 October Gold ($1060 strike) call options for a credit of 50 cents or $50 gross. Specifically this means that between now and expiration in 13 days we have the right to exercise and be long one October Gold futures contract at $1045, and on the other side of the transaction, the buyers of the 2 October Gold ($1060 strike) call options have the right to exercise us, since we are short those two options, and force us to sell 2 October Gold futures contracts at $1060. They wouldn’t do that to us unless October Gold is at or above $1060, typically at expiration. So at expiration, in 13 days, we can calculate exactly where we will stand financially depending on where the futures price is at that time. So here are the potential results:
1. If in 13 days, October Gold closes at a price that is at or below $1045, then all call options from strikes of $1045 and higher will expire worthless. The result for our position would be that since we took in $50 gross up front, all the options would expire worthless and we would keep the $50 in gross money. Gross means before commissions.
2. If in 13 days, October Gold closes over $1045, the our $1045 strike call option will have $100 in value for every dollar prices are over that level until prices reach our top strike price of $1060. So, for example, if in 13 days, October Gold closes at $1050, our $1045 call will have a $5.00 value, or $500 gross, and the $1060 calls would expire worthless. Mechanically, the exchange would automatically exercise the October Gold $1045 strike call option and show us long one October Gold futures contract at that price. We in turn, would sell short one October Futures contract at the closing $1050 price. The resulting statement you would receive would show a buy of one October Gold futures contract at $1045 from exercise and a sale of one October Futures contract at $1050, resulting in a liquidated trade for a $5.00 per ounce gross profit. So you can see that if prices close right at $1060 on expiration date, you could potentially make a profit of $15 per ounce, or $1500.
3. If in 13 days, October Gold closes over $1060, then you know that the one buy at $1045 offsets with one of the short calls at $1060 for the $15.00 per ounce gain ($1500), but you would still have one extra short $1060 strike call option that you would need to be worried out. At expiration, for every dollar per ounce October Gold is above $1060, you would be giving back $100 of the $1500 gain from the one lot $1045 to $1060 spread. So, that means that you would have a $15 per ounce cushion above the $1060 level before you begin to lose money, or $1075. So, for example, if in 13 days, at expiration, October Gold closes at $1070, the result would be—a gross gain of $1500 (the difference between one long October Gold $1045 strike call offset with one short October Gold $1060 strike call option of $15 per ounce) minus $1000 gross (short one extra October Gold from $1060 and liquidated at the close that day at the close of $1070, or $10 per ounce loss) for an overall gain of $500 gross plus the $50 credit they gave us to do the trade up front for a grand total gross gain of $550. Keep in mind that any of these options can be liquidated prior to the expiration date.
4. If in 13 days, October gold closes over $1075, then you would be losing $100 for every dollar per ounce gold closes over $1075. This is an unlimited risk above $1075, so we have to constantly monitor this trade.
5. Between now and 13 days, all these options will still have some “time value” involved in the price of the option. The value of “time value” in options depends on how much time is left until expiration and how volatile the underlying market is. There is no exact way to calculate what those values would be. So, since there are only 13 days left until expiration, there is not a lot of time value left in these options, but since gold has been volatile lately in its price action, there is still some lingering time value. This is important, because if something crazy happened and prices suddenly jumped up to the $1060 area in the next few days, we would need to quickly evaluate where our trade is at that time and decide whether to liquidate, because all the call options would be moving up in value. Our hope would be that the single $1045 call would be going up hopefully faster that the 2 short $1060 call options in value. As time value erodes, the $1045 call should outpace the $1060 calls, but the key is to have most of the time value eroded by the time volatility spikes. So, in this trade, we are hoping that October Gold gradually rises to the $1060 level over the next 13 days, or if prices stay down here, that prices spike up towards $1060 on the expiration day. If prices spike up to the $1060 area to quickly, we would need to probably look to exit the trade, hopefully with a gain at the time. The closer we are to the expiration date, the better off we will be.
So, since there is 70 days of time value left in the December options, and I think there is a good chance for a strong rally, I chose strike prices that are up in the areas where I think prices could get to by then, and I recommended the February trade in the same fashion. In those two trades, we have a much wider strike price spread that gives us a lot more profit potential and a much greater distance prices would have to rally before we would get into any trouble.
What I like about these types of trades is that when volatility rises, many, way out-of-the-money options get overvalued enabling us to put on 1 by 2 ratio spreads for credits, and giving a large target zone to make a profit in. I always like to get into trade where we are paid a credit up front, knowing that if I am totally wrong, and gold goes down in price all the way to expiration, then we still wind up with a gross credit and we virtually didn’t lose any money, or very little after commissions. But at the same time, if prices rally up into our range, a lot of profit is possible. We just have to make sure that prices don’t spike up too quickly to or past our highest strike price. If so, we evaluate and decide whether to get out or not. In many cases we will already have some profit made at the time, so the decision may not be difficult on what to do.
By the way, it is also possible to do other ratios, like 1 by 3 or 1 by 4 spreads, but the potential risk goes dramatically higher as well.
Call me if you have any questions on ratio option spreads.
Sep. 14, 2009
David Hall
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