Playing Both Sides Of The Gold Market

12/02/08 08:57:23 AM

by Donald W. Pendergast, Jr.

For traders who are unsure of market direction, selling high-volatility, deferred-month options can be an interesting and potentially profitable alternative.

Security: GC
Position: N/A

Sometimes gold is hot and sometimes it's not, but you can be certain that there are strong opinions and emotionally charged biases among gold bugs and gold bears. But what if you're neither bull nor bear, unsure of how to time an entry into the gold market? Is there a strategy that can allow such a noncommitted trader to craft a potentially profitable trade entry into one of the most volatile markets in the world? Yes, there is, and here are the essentials of how to go about it.

FIGURE 1: GOLD, WEEKLY. A mixed longer-term technical outlook, combined with a variety of significant support/resistance barriers, makes selling a short strangle an interesting alternative, especially when implied option volatility is high.

Graphic provided by: MetaStock.

For starters, let's peek at the weekly gold chart (Figure 1), where I've detailed the major support and resistance levels and have also plotted the long-term up trendline and the large descending broadening wedge pattern. In the subwindow, Pring's Special K indicator is also plotted. Essentially, the chart paints a somewhat mixed technical impression, one that is biased toward more of a bullish price projection over the short term. Longer term, anything can happen, and a trader who isn't exactly sure how to trade gold now, what with its mixed longer-term outlook, might want to examine the various option strategies that can put gold's high current volatility levels to good use.

FIGURE 2: GOLD, WEEKLY. High volatility in gold translates into inflated option premiums. Here, a trader selling an April gold 1700/550 strangle would collect approximately $800 in option premiums.

Graphic provided by: MetaStock.

An industrious trader, one bent on putting high volatility to work in a nondirectional options trade, would first examine the current volatility for gold. After learning that April gold's volatility is right near the top of its two-year range, he decides to sell an April 2009 short strangle, a strategy that sells deferred-month, out-of-the-money puts and calls. Our trader then contacts his broker and learns that he can sell a gold April $550 put option for about $400 and a gold April $1,700 call option for about $380. As long as the April 2009 gold contract stays within the range of $550 on the downside and $1,700 on the upside, our trader will get to keep all of the option premiums — nearly $800. Gold would have to more than double in the 118 days until the April contract expires (on March 26, 2009) for the short $1,700 call to go in-the-money, while gold would have to take out significant support levels near $640 and $550 before the short $550 put goes in-the-money.
Even better, since our trader believes that gold at $550 is an outstanding buy, he has no problem if he gets assigned on the short $550 put. He also finds it improbable that gold would increase to $1,700 in less than four months, so he feels relatively safe selling such a far out-of-the-money call option.

Plotting the profit range on the weekly chart brings the profit zone of the April gold 1700/550 short strangle into better focus. There's a 1,150-point range of profits on this option spread at expiration, not something seen everyday in the gold market. Another aspect of this trade that makes it so tempting is that if option volatility decreases substantially, premiums will shrink dramatically (especially as time decay takes its inevitable toll), allowing a nimble trader the ability to close out the spread before expiration at a substantial profit.

Profits are one thing, but what about closing the trade early if price moves too far, too fast in one direction? This is a very real possibility in the gold market, and a very simple exit strategy to consider might be this: When either the short put or call doubles in value, close the spread. If this happens, one side of the spread will likely have shriveled substantially, meaning that the overall loss on the entire short strangle will be modest.
Really brave traders might simply close out the side of the short strangle that doubles, holding the other short option that's opposite the trend move that caused the other option to double. It's more risky to do that, but it could still be a viable strategy for an experienced trader. See Figure 2.

Selling a short strangle when option implied volatilities are at extremes can be a viable strategy for traders who are hesitant to commit capital to a directional futures trade. When strike prices are chosen that require multiple support/resistance barriers to be taken out before going in-the-money, a trader can make it more difficult for the trade to lose. Even better, since option volatilities normally revert to more normal levels and since time decay guarantees that every option expires with zero time premium, such a trader has put the odds of success squarely in his favor.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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