Gold has rallied to record highs this week, with December COMEX futures trading up above $1,275 an ounce. Gold’s bull run has been good to investors, but if you aren’t involved, it’s not too late to take advantage of opportunities in this market. I think gold still has room to run, and a carefully planned options strategy can allow you to access the market with defined risk and a good range to turn a potential profit.
There are a lot of factors causing gold to rally. It has benefited from safe-haven demand tied to the European sovereign debt crisis as well as ongoing U.S. economic weakness. An intervention in the Japanese yen could lessen the yen safe-haven play investors have favored, and that could shift assets to gold. As the economy improves, future inflation fears should also keep gold in the spotlight as a hedge.
Gold Bull Call Butterfly Spread
A bull call butterfly spread enables a trader to enter the market with defined risk, while providing a large range for the trade to turn a potential 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. (It 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 June 2011 Gold 1300 call at $86.00
Sell 2 June 2011 Gold 1400 call at $53.50
Buy 1 June 2011 Gold 1500 call at $35.00
Ex. Cost of spread $86.00 (1300 call) + $35.00 (1500 call) – $107.00 (1400 calls *2) = $14.00.
Remember, gold is $100 per dollar move; so $100 * $14.00 = $1400 Breakeven occurs by taking the premium paid for the spread plus the plus transaction 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. = 1300 call + $14.00 + transaction costs = 1314 + transaction costs
BE 2 = Higher option Strike bought – net premium paid – transaction costs
BE 2 Ex. = 1500 call – $14.00 = 1486 – 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, June Gold at 1400 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. 1400 (short call) – 1300 (lower long call) – $14.00 – transaction costs =$86.00 – transaction costs. =$86.00 * $100 = $8,600 – transaction costs
Max Loss= Net premium paid + transaction costs Max Loss ex. = $1400+ transaction costs
Expiration is May 25, 2011.
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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