Gold kicked off the week on a bullish note following better-than-expected economic reports and news of large Indian central bank purchasing. COMEX December futures surged above $1,085 an ounce Tuesday, passing the record high hit October 14 at $1,072. I think gold should remain strong in coming months as an inflation hedge an investment vehicle. Traders who wish to capitalize on this trend might consider a gold option ratio spread, which I will outline.

This week’s early data included the Institute for Supply Management’s factory index, which rose to 55.7, a three-year high. September pending home sales came in better-than- expected, rising for an eight straight month at 6.1 percent. The Commerce Department reported U.S. factory orders rose 0.9 percent in September, the fifth increase in six months.

European central banks have made some statements that they were pegging gold as an important asset for central banks and a good market to diversify against risk. On Tuesday, India’s central bank was reported to have bought some 200 metric tons of gold from the International Monetary Fund in late October. That favors the bull camp, no doubt.

Gold has gained roughly 20 percent this year as the U.S. dollar has slumped. The U.S., Dollar Index futures, which tracks the dollar’s performance against six major currencies, is down 5.7 percent this year.

Looking at the gold chart, you can see the pattern of climbing, followed by consolidation.

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I think gold prices are poised to move higher over the next several months, for several reasons. If the data hints the economy is starting to recover, we could see an inflationary impact. And, the dollar is expected to move sideways to lower, and dollar weakness has been supportive of commodities.

Some could argue gold prices are overbought. We are at contract highs; but that doesn’t mean it can’t move higher. And I think it will. With the ratio spread strategy I will outline next, you can capitalize on a rally, but if you are dead wrong and the market sells off, you can walk away relatively unscathed.

Ratio Spread
If you are bullish, you can consider buying a Feb gold 1050 call, which is at-the-money and expires at the end of January. That’s a pretty expensive proposition, however. Each $1 move in the 100-ounce (big) gold contract is $100. So, if your 1050 call option costs $46 x $100 for a $1 move, equals $4,600 to buy the option. To finance this, consider a ratio spread. You could buy one 1050 call, and sell three February 1150 calls. Those cost about $16 each, x 3 = $48 x $100 = $4,800. So you paid $4,600 for the 1050 call, and brought in $4,800 by selling the 1150 calls. So your gross credit is $200, not including your commission costs. There is obviously risk involved. You are naked two 1150 calls, so you face unlimited risk. One of the 1150 calls is covered by your 1050 call, so you still have unlimited risk on the other two.  There are ways to reduce your risk further, which I will examine.

But let’s look at the breakeven level on this trade, and potential profits if the market works in our favor. A move from $1,050 to $1,150 is $100. If gold breaks out above $1,070, and come expiration at the end of January, gold is at $1,150, the trade would be worth $100. Since you had a net credit on the ratio spread (remember, your 1050 call purchase was more than offset by the sale of the 1150 calls) You could potentially make $100 x 100, or $10,000 plus your $200 credit, or $10,200. That’s your maximum profit potential, not including commission costs.

Say the market moves to $1,150 at expiration. You would take that $100 you made on the way up, and divide by your two naked calls (remember the other is covered by your 1050 call), and you’d get $50. Adding that to the 1150 strike price gives you $1,200 as your break-even level. You would not gain or lose any money on a gold move to $1,200. The sweet spot for this trade is $1,150, but you can potentially make money between $1,050 and $1,200. That gives you a $150 window.

As mentioned, this strategy isn’t for everyone, and carries substantial risk. But keep in mind that while the idea of naked calls may seem scary, if you are trading futures, your risk is also unlimited. The risk is essentially the same whether you are trading an outright futures position, or the naked option.

Risk-Management Strategies
To reduce your risk, there are other risk-management strategies you can pursue. You can keep the 1×3 ratio spread in February, but add then positions in December options, which expire at the end of November. You can buy two December 1150 gold calls, which cost about $150 each. Now, you are introducing another level of risk management. You have calculated risk on this trade. You can still lose money due to differentials in time value, but say gold prices shot up to $1,200. Those 1150 December calls would be worth $5,000 each, while your 1050 Feb call is worth $150, and your three Feb 1150 calls would be worth at least $50 each.

Your margin for this particular trade is approximately $1,419 (subject to change). That’s substantially below the actual margin required if you were to trade an outright gold futures position.

There are certainly pros and cons to every strategy, and unique risk profiles. There is too much to delve into here. But if you use the right strategy, and understand it, you can potentially stay in the market even though there are day to day price fluctuations. You can possibly smooth out your equity curve, and stay in the market. Feel free to give me a call with any questions you might have about this topic, or for other market-related information and strategies.

Mike Sabo is a Senior Market Strategist with Lind Plus, Lind-Waldock’s broker-assisted division. He can be reached at 800-798-7671 or via email at msabo@lind-waldock.com. Follow Mike on Twitter at www.twitter.com/LWMSabo.

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