Spinning Straw Trades Into Gold

Here's a fun chart that illustrates why I like gold.  Don't take it too seriously but do take seriously that this is exactly what happened to the US when we got embroiled in the Vietnam war and Nixon took over and the country plunged into debt and we cut taxes to the rich and dropped the gold standard.  The ratio of the Dow to gold dropped from 47:1 to 2:1 but the middle of Reagan's first term.  During the Clinton years, as we moved towards a budget surplus, the ratio of Dow to gold jumped from 7:1 in 1993 to 40:1 in 2002 but, since then, has dropped back to 15:1.  The bottom line is:  If you are worried about the markets – buy some gold.  If you are worried about the dollar – buy some gold.  If you are worried about terrorism – buy some gold. 

I still think we should get a correction in gold back to $875 (no longer $850 as the trendline has been yanked up) but we're not hedging gold because we are worried it will hit $1,000, we are hedging because we are worried it will hit $2,000.  That means that the difference between buying gold at $850 or $950 is not a big enough deal to stay completely out of it now.  We would LIKE to be in the 2011 $70 calls for $20.  Sadly, they are $32.25 at the moment.  Here is how you can use a rolling plan to enter something high and still be happy when it's low. 

• We pick a target amount of gold.  Say 10% of our virtual portfolio and say that's $10,000.
• We scale in so we buy $2,500 at a time (roughly)
• We FIRST look at what rolls cost.  The roll from the $120s to the $115s is $1.  Well that's silly, we'd pay that now.  The roll from the $75s to the $70s is $3 so let's say we'll be happy to spend $1.50 a roll.  THEREFORE we buy in at the first strike we CAN'T roll down for $1.50, which is the 2011 $100s at $19. 
• If we plan on spending $1.50 per $5 roll down as gold falls, it will cost us $9 ($1.50 x 6 rolls) to get down to the 2011 $70s.  That would put us in for $28 total dollar and now the question is – is it worth giving up $30 in position advantage over our potential callers in order to save $4.25?  No, not really.  The delta on the $100s is .51 and the delta on the $70s is .83 so that $4.25 blown as soon as gold moves up $13.

OK then – back to scratch and we'll look at this again.

• As we are short-term bearish we'll work backwards from a bearish cover, the Apr $92s for $4.60.
• So, where does a $92 caller give us the best roll for $4.60 in a position we can live with if gold instead takes off? 
• Looking over a bunch of strikes, I can live with the Sept $85s at $14.75. 
• That puts us in a $7 spread for $10.15 and we can allocate 2 contacts ($2,030) for the first round.  That way, if gold goes up $100 by  Apr 17th, we can expect the calls to be $21.40 (the price of the Sept $75s) while we would owe the $92 caller $12.  At that point, we would be able to buy 2 more long calls (probably the Sept $95s for $14ish) and roll the callers to 4 more long calls at $4.50.  The cost of that round would be another $2,030 (about) for the calls and $600 to make up the difference in the roll of the callers.  If gold goes up another $100, we can do that again one more time before we're fully invested. 

Of course we will hopefully not just sit there and let this happen to us like dumb bunnies but it gives us levels to watch and an upside plan.

On the downside, the $4.60 we sold SHOULD give us a roll of 10 strikes.  You calculate this by going $4.60 LOWER in price on the same month as it gives you a better idea of where the spread would be if gold drops (but the VIX may go up and change the deltas).  That means we are pretty much protected against a $100 drop in gold between now and Apri 17th and, since $850 is our downside target, we can live with that and will be happy to roll down and buy another round at that price or lower if we need to. 

So this plan commits just $2,030 out of $10K to a downside that we think may chop our 2 Sept $85 calls down to $10.10 (even) and commits us to a strategy of being in for $4,660 if gold goes up $100 with 2 Sept $85 calls that SHOULD be worth about what the $75 calls are now ($21.40) and 2 Sept $95 calls at the $14.75 the Sept $85 calls are fetching now.  That's $7,230 worth of contracts at $85 and $95 covered by 4 May $102s.  Since our net spread is $17 on one set and $7 on the other, it means we would have $4,800 of intrinsic value to our callers for $4,660 if all goes according to plan. 

That may not sound tremendous to you after a month's work but the key is to mitigate the entry risk as we have eliminated most of our long premium of the first round and have great upside leverage while staying about 38% covered overall (average $12 intrinsic value covered by $4.60 callers).  Once you have 4 longs and 4 callers, you can then apply simple stops to the new callers (1/4 off at 25%, 1/4 off at 50% gains) and you give yourself plenty of room to run. 

This is a BEARISH entry to gold because we THINK it's going down, not up, but we don't want to miss a rally just in case.  So our plan is to at least make sure we can establish a position that is well in the money and we will still have half our firepower ready to jump on the momentum train (against short calls that are already covering our original position) if things do take.  Ideally though, we are patiently waiting for a better exit and picking up some caller income while we wait.   Keep in mind that Wednesday's gold move was VIOLENT, dropping down to $87 from $90 before flying up to $94.   Of course, if you were covered and rolled down your longs for $1.50 and then stopped out 1/4 of your callers when they gained 25% off the bottom, you would have been thrilled right? 

Keep in mind this is disaster protection, not a trade we really WANT to win as it means inflation is out of control and our currency is collapsing but holding, ultimately, $10,000 worth of GLD under $100 if gold goes to $2,000 (GLD $200) would be $40,000+ on 4 contracts.  That can offset a lot of inflation! 

Remind me to update this trade as we move forward, it would be good to keep trade comments under this post so we can see how it pans out over time! 

Another way to play gold more aggressively is to use the UGL Ultra Long Gold ETF at $35.80.  Realistically, this should only gain $17.90 ($53.70) if gold goes to $1,200 but, if gold drops to $750, this ETF should lose about 40% ($14.32) to drop to $21.48.

Here's a fun way to get some free downside protection against a longer positon:  You can sell the Oct $48 calls for $4.45 and you can sell the Oct $30 puts for $5.75 and you can buy the Oct $41 puts for $11.30 (net $1.10).  That means that, for net $1.10, if gold falls 20% you can expect to collect you vertical put spread of $11, + $9.90.  The only way you lose is if GLL goes above $40 (forgetting the dime) and you don't lose more than $1 until GLL crosses $48, up 35%, which would be a 17% gain in gold to $1,110.

Now we can look back at GLD and see if that helps us.  We plan on buying the Sept $85 calls for $14.75 so at $100 we are fully in the money and gaining dollar for dollar.  If GLD goes to $111, then these calls will be at least $26 BEFORE we have to worry about paying back the GLL caller.  We also know that these ETFs don't work all that well and that it is unlikely GLL will get the full benefit of gold's rise – good to keep in mind but not something we should base our math on.  So is it better to use these puts as cover rather than the GLD callers? 

Since it pays twice as much as the GLD callers ($4.60) on a 20% drop, they do make a better safety net and the upside risk isn't partciularly worse since a 20% gain would put our $92 callers $9 in the money so it is more limiting to our upside by a long-shot.  The reasons they are not my first choice as a cover are margin and confusion.  You may have serious margin issues selling naked calls but, if you can do this and manage the stops, it's worth the hassle of tracking another position.

So lets call that a play:

Net cost $4,980, no margin.  At $117 this trade profits $3,304 so no problem offsetting what we may owe the UGL caller, even if we do get blown out.  If UGL doubled to $70, we would owe 2 x $22 to the $48 callers or $4,400 but a 50% gain in GLD to $140 would give us 2 x 55 on our $85 calls ($11,000) of naked upside so no issue there. 

Of course, if GLD falls below $90, we can cover with $90 calls and set a 25% trailing stop on 1 of the $90 callers and one of the $92 callers immediately, recovering any time we fall below $90. 

Net cost $220, probably $1,780 margin requirement to provide $1,980 in additional downside protection.  Be very aware that is you end up paying .50 more for your net entry, you are giving up $100 in downside protection.  As these options are more thinly traded, you may want to fill them first. 

As time goes on we'll compare the simple play to the more complex one and see which fares better.