Following the Smart Money Into Gold, With Limited Risk
Some analysts believe gold could be a big winner in the next few months. There are a number of reasons for optimism.
One reason for optimism is the fact that gold is a tradition safe haven in times of turmoil. In the current market environment, turmoil, and the potential for even more turmoil, is high.
For example, there are a number of political concerns that could move the stock market. The upcoming election in the United States could lead to a split government with Democrats controlling at least the House of Representatives and Republicans holding the presidency and perhaps the Senate.
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This could lead to gridlock as the two parties refuse to compromise. It could also lead to investigations into each other and continued talk of Constitutional crises as each party seeks an advantage.
Outside the United States, there is Brexit. The United Kingdom is moving towards leaving the European Union (EU) early next year. It’s an unprecedented event that neither side has a comprehensive plan in place for.
Also in Europe, Greece and Italy appear to be economically weak and either of them, or even another member of the EU, could plunge the eurozone into crisis, yet again.
In Asia, China and North Korea are competing for attention and either or both could spark a global crisis. This is especially true as trade rhetoric increases with China. The Middle East, of course, can never be far from the minds of traders as oil prices rise.
Finding Safety in a Challenging Environment
For traders, the question is not about politics or international relations. The question is which assets could benefit from a possible crisis and how they can best position themselves for the possibility of turmoil. Gold is, as it always is in times of crisis, one asset that traders should consider.
The weekly chart of SPDR Gold Trust (NYSE: GLD) is shown below. The price appears to be near support.
Note the relatively narrow trading range of the past eight weeks. A breakout from that range is likely. And, there are reports that central banks and commercials in the futures market were buying at these levels. That could be bullish.
However, there is significant downside risk in the trade. The longer term chart using monthly data indicates significant support could be more than 10% below the current price.
An options strategy could provide a useful tool for investors who want to limit risk.
A Trade for Short Term Bulls
As with the ownership of any stock, buying GLD could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high prices stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for GLD
For GLD, the March 15, 2019 options allow a trader to gain exposure to the stock.
March 15, 2019 $113 call option can be bought for about $3.47 and the March 15, 2019 $120 call could be sold for about $1.18. This trade would cost $2.29 to open, or $229 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $229.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in GLD the maximum gain is $4.71 ($120 – $113 = $7.00; $7.00 – $2.29 = $4.71). This represents $471 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $229 to open this trade.
That is a potential gain of about 205% in GLD based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.