The recent pullback in gold to below $1,200 an ounce looks like a good opportunity for bullish investors who may have missed the move up to consider buying at cheaper levels. A bull call butterfly spread can be an appealing strategy for bullish investors looking for defined risk.
Gold can be considered an insurance play, and I think investors will continue to flock to gold when there is distressing news or fear in the market. Last week, we saw six new bank failures make headlines, bringing the 2010 total to 96. We saw 140 bank failures in 2009, 25 in 2008 and only three in 2007. We are only half-way through the year, so we could surpass last year’s levels. It just shows that banking and housing problems are far from over.
There are other factors that could drive gold. A breakdown in the stock market after we get through earnings season and into the fall is a definite possibility—particularly if we don’t see the employment picture improve. In Europe, the sovereign debt crisis has not yet been resolved, even though some countries are taking steps to reign in spending. Portugal and Spain have been able to roll their debt that’s coming due, but they are just buying time. They will have to face these obligations eventually.
Gold has also historically been a hedge against Inflation, which tends to follow the types of fiscal and monetary stimulus measures that have been put in place in the U.S. While it hasn’t shown up yet in the U.S. Consumer Price Index or Producer Price Index, that doesn’t mean prices will stay down forever. In Congressional testimony this week, Federal Reserve Chairman Ben Bernanke said he is prepared to take further action to support the economy if necessary, but expressed reluctance to do so. The economy is still under stress, so I don’t think we can rule out additional stimulus that could result in inflation.
“The best approach, in my view, is to maintain some fiscal support for the economy in the near term, but to combine that with serious attention to addressing what are very significant fiscal issues for the United States in the medium term,” Bernanke said.
A run on the physical market is also a possibility for gold. We saw this in the cocoa market recently. London cocoa hit a 33-year high last week as an investor accumulated a massive amount of cocoa futures positions on the NYSE Liffe exchange. There were 24,866 contracts for July delivery open on the exchange, equivalent to 248,600 metric tons. That’s more than amount available in storage and approved for delivery.
Technical Factors
A break over $1,220 on good volume would be a strong bullish technical signal. You can see the trend in gold has been strong, even with a few fluctuations. I see a target of $1,300 likely by year-end. We see a triangular pattern on the far right of the chart in 2007, when we saw the breakdown in the housing market begin. Some of the government stimulus measures that helped fuel the recovery, including government bailouts, the cash-for-clunkers program, home buyer credit have caused some downdrafts in gold. It’s not likely to move straight up, but I think the outlook remains bullish for many reasons. In the short run, the market could trade sideways for bit.
Gold Trading Strategy
A bull call butterfly spread enables a speculator to enter the market with limited risk while providing a large range for the trade to turn a profit.
Simply, the bull call butterfly spread is a bullish strategy that is a combination of a bull call spread and a bear credit spread. The trade has limited profit potential and defined risk. It involves three strike prices and can be constructed on either the call side or the put side.
The basic construction on a bull call butterfly spread is to buy a call at a lower strike and also a higher strike while selling two calls at the same strike in the middle of the two calls purchased. (Sounds complicated but after an example you should have a firm grasp of the construction, risks and profit potential).
Construction
A. Buy one (at or slightly out-of-the money) call option.
B. Sell two call options at a higher strike.
C. Buy one option that is equal distance from the first bought and the two sold.
Example
Buy 1 December Gold 1250 call at $32.00
Sell 2 December Gold 1300 call at $19.50
Buy 1 December Gold 1350 call at $13.00
Ex. Cost of spread $32.00 (1250 call) + $13.00 (1350 call) – $39.00 (1300 calls *2) = $6.00
Remember gold is $100 per dollar move; so $100 * $6.00 = $600
Breakeven occurs by taking the premium paid for the spread plus the plus transaction (commission) costs added to the lower strike bought and also subtracted from the highest option bought.
BE 1 = Lower option Strike bought + net premium paid + transaction costs
BE 1Ex. = 1250 call + $6.00 + transaction costs = 1256 + transaction costs
BE 2 = Higher option Strike bought – net premium paid – transaction costs
BE 2 Ex. = 1350 call – $6.00 = 1344 – transaction costs.
One of the benefits of the bull call butterfly spread is the ability to purchase a near-the-money call option with minimal out of pocket expense. The maximum profit potential occurs when at expiration of the options the futures market is trading at the center strike price (the two options sold). In this example December Gold at 1300 at expiration will provide the maximum profit potential.
Max profit = Strike price of short call – strike price of lower bought call – net premium paid – transaction costs. Max profit ex. 1300 (short call) – 1250 (lower long call) – $6.00 – transaction costs =$44.00 – transaction costs. =$44.00 * $100 = $4,400 – transaction costs
Max Loss= Net premium paid + transaction costs
Max Loss ex. = $600+ transaction costs
Expiration is November 23, 2010.
If you are bearish gold, you can also take the opposite approach—and construct a put butterfly spread.
Feel free to contact me with any questions you have about the markets, and to develop a customized trading strategy based on your unique goals and risk tolerance.
Phil Streible is a Senior Market Strategist with Lind-Waldock. He can be reached at 800-803-8037 or via email pstreible@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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