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As Gold Prices Climb, This Options Trading Strategy Tells You When to Buy

By , Contributing Writer, Money Morning •

While most experts agree the long-term outlook for gold prices is still bullish, the yellow metal's pattern this summer can only be described as one of fits and starts.

In all, gold has made 11 short-term bottoms since May 29, the lowest being a close at $1,552.40 an ounce on June 28. Meanwhile, subsequent rally attempts have all quickly run into resistance, stalling out at near $1,620.

This start-and-stop action makes it extremely difficult for investors to avoid being "whipsawed."

Fortunately, there's a way around this dilemma: Just use an options trading strategy that lets the market itself tell you exactly when to buy gold.

And, here's the best part: This clever options trading strategy will cost you only a few dollars.

It can be used on gold futures - e.g., the standard 100-ounce CME Group contract, on any of the gold mining stocks or on the much more affordable gold-backed exchange-traded funds (ETFs) on which options trade.

Taking the Guesswork Out of Gold Prices

For ease of explanation, I'll base our example on the most popular and actively traded of the gold ETFs - the SPDR Gold Trust (NYSEArca: GLD).

Recently quoted at $155.75, the price of a single GLD share usually tracks the price of one-tenth of an ounce of gold (discounted by 2.5%-3.0% for fund expenses and storage costs for the metal that backs the shares).

Here's how you would initiate the strategy, based on actual prices available last Friday:

  • BUY an out-of-the-money call option with a strike price $4.00 to $5.00 above the current price of the underlying GLD shares and an expiration date four to eight weeks out. Using GLD's July 27 price of $157.25, that would mean buying a September $162 call, priced at about $2.48 a share, or $248 for the full 100-share contract.
  • SELL an out-of-the-money put option with the same expiration date and a strike price $4.00 or $5.00 below the current GLD share price - ideally one just above the lowest price in the most recent series of up-and-down swings. In this instance, that would mean selling the September $152 put, priced at about $2.21 cents, or $221 for the full contract.

The cost of the combined position is thus just 27 cents ($2.48 - $2.21 = $0.27), or $27 total.

For simplicity's sake, I'm using single options in the example. In practice, you'll buy and sell one option pair for each 100 shares of GLD you want to purchase, and the cost will rise proportionately.

You will also have to post a margin deposit to cover the sale of the short put. In this case, that would be about $2,620 - but you'll get it all back in eight weeks unless the put is exercised and you get to buy GLD at $152.00 a share.

And what do you get for your $27?

In brief, you get a position that takes the guesswork out of when to buy gold - or, more precisely, shares in the GLD gold ETF - and also cushions you against limited short-term volatility.

How This Options Trading Strategy Works

Between now and the September 21 option expiration, GLD share prices can fluctuate as much as they want between $152 a share and $162 a share, and it won't affect you one way or the other.

You can just sit patiently, waiting for the price of gold - and GLD's share price - to make a decisive move. If they do, one of two things will happen:

  • GLD will break out of the recent trading range to the upside, moving above $162.00 a share. You can then exercise the call and buy the shares at that price - regardless of how high GLV's price might have moved above that level. (Alternatively, you can simply sell the call just prior to expiration.)
  • GLD will again fail in its rally attempt, with the price turning lower and falling below $152.00 a share. The put will thus be exercised and you'll have to buy GLD at that price. That's a substantial bargain over what you'd pay if you merely bought the shares today - plus you'll be getting in just above the $151.00 support level established in the recent series of gold price swings. (Again, if you prefer, you can just buy back the put shortly before expiration.)

Either way, you'll have avoided a lot of anguish over when to buy and whether you've made the right decision.

Plus, as Table 1 illustrates, if gold prices rally substantially, you'll make almost as much profit as if you'd laid out the $15,725 to buy the actual shares in the first place - and your return will be much, much higher.

For example, if GLD climbed to $170 a share, you'd make $1,275 in profit, or 8.1% on the shares.

But, on the option combo, your profit would be $773 (the $1,275 reduced by the out-of-the-money amount of the call, and the cost of the combo) - a whopping return of 2,862.9% on your $27 outlay.
Even if you consider the $2,620 margin deposit as part of the cost, the return is still an outstanding 29.2% - in less than two months.

Even better, if gold prices drop and GLD falls below $152.00 a share, your loss is actually $498 less than if you'd bought the ETF itself - simply because you avoid the entire decline from $157.25 to $152.00.

And, if gold merely sits there, staying in its recent range, your total loss is ... that's right, just $27!

This play can be used repeatedly until gold prices finally move out of their recent range. Note as well that the selection of option strike prices should involve a little more analysis than the generic guidelines offered here.

If you plan to seriously utilize this strategy with gold - or any other stock, ETF or futures contract - you should first examine a technical chart for the underlying security, then buy calls with strike prices just above primary resistance levels and sell puts with strike prices just above major support.

That way, if the options are exercised, you'll be buying the underlying security only on a confirmed breakout, or at a bargain point where the price is unlikely to go much lower.

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