If you are a long-term gold bull but can’t stomach the day-to-day volatility in the market, you might consider an options strategy that allows you to more easily weather the ups and downs. I think there are plenty of good reasons to own gold no matter what the economic climate holds through the rest of this year.

December gold futures hit a new all-time high on Tuesday, September 14, rallying to above $1,270 an ounce. Gold has been in a bull market for some time, but has seen some corrections. Many long-term traders have a difficult time holding a position through these volatile periods. When a downturn occurs, they often panic and get out. A carefully planned and understood options strategy can help traders stay in the market through these periods. And, trading options can offer more advantageous margin rates than futures.

If you are bullish gold and this type of strategy sounds appealing, I will offer an example of a trade I have been recommending for clients. It involves buying a December gold $1,275 call for $24.50, selling a December $1,160 put for $9, and selling two December $1,375 calls for $6 each. Keep in mind, options prices change, so this example is based on pricing as of Monday, September 13, 2010.  Gold is a 100-ounce contract, so a $1 move in option premium represents $100.

Here’s how this trade breaks down. Selling the put and the two calls nets you premium, so you collect $9 + $6 + $6, or $21. Buying the call would cost $24.50, so you end up with a net cost of $3.50 ($350 for the four options), not including commission charges. For the sake of simplicity, say you pay $50 per round turn or $200 for commissions. That gives you a cost basis of $550.

You face unlimited risk on your one short (naked) put, as you would if you were long a futures contract. However, research has shown about 80 percent of options bought and held to expiration wind up expiring worthless. As an options seller, while you do face unlimited risk, the odds are greater that the option will expire out-of-the money and you will not be assigned a position. The most you can lose on the options you bought is the premium you pay, so your risk on those options is defined for you.

Let’s assume gold moves to $1,375 by expiration. That represents a move of $100. Your cost basis was $5.50, so that leaves a net of $94.50. So your maximum profit potential in this scenario is $9,450. December gold at $1,375 is your sweet spot.

If, however, gold moves above $1,375, assuming you do nothing, that naked $1,375 call starts working against you. Adding $94.50 (your net profit) to $1,375 (your short call strike price) gives you a breakeven on the upside at $1,469.50. So as long as December gold stays above $1,280.50 and below $1,469.50, this strategy will be profitable at option expiration.

Let’s say the market is above $1,160 but below $1,275. If you did nothing you’d lose $550. Of course there are a range of possible profit/loss scenarios with this strategy, depending upon what strikes you have on and if you adjust the positions. I would be happy to discuss further if you wish to contact me.

I think gold represents a good investment over time, and having a position in gold is a good idea for investors who wish to diversify their portfolios. If the economy starts to recover, I believe gold prices will still continue to rise. Why? Because I believe they will take their time before they pull out the excess stimulus, therefore we could see inflation start to materialize. Gold is a hedge against inflation and that should give investors reason to continue buying gold. On the other hand, if things get worse, gold prices could still go higher, as gold is perceived as a safe haven asset during times of distress. By year-end, I think gold should be above $1,300.

Please feel free to call me to discuss this strategy in further detail, or with other questions you might have about the markets.

Mike Sabo is a Senior Market Strategist with Lind-Waldock. He can be reached at 800-798-7671 or via email at msabo@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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