Monday, April 15, 2013

Look into the Future of Gold with Options

Okay. Today gold is dropping like a hot rock, but there may be a silver lining. No pun intended. I took a look at the January 17, 2015 calls for GLD and was not too surprised to see that the calls are still priced very high.

A quick refresher on Call options is appropriate here. There are two sides to options. One person is betting on the price to go up when you Buy a Call. The other side is a person who thinks the price will go down which is where you Buy a Put or Sell a Call for the income stream. Most options are 3 calendar months in duration. However, longer dated options are available that mature in January of each year.

Normally, when a security drops in price, the call options also drop in price precipitously. However, with GLD, this is not happening with longer term options. The price of Buying a 161 GLD Call maturing o January 17, 2015 is 6.00 per 100 shares.  In other words, if you thought GLD was going to hit the price of $161 per share, (it is priced at 6.00 per 100 share contract as of right now,) then you would load up on these call options. However, you would have to risk the premium of $600 that 100 shares of GLD will be over $161 per share on January 17, 2015. You only make money by what it exceeds the $161 price. Imagine if you bought 10 options at this price. You would have to put up $6,000 to get the $161 strike price. Yikes! That's expensive.

Think about this for a minute. If people really believed that GLD was going to tank and continue to go down, then the price of this 161 Call option would be cheap, cheap, cheap. The reason for this would be because investors would have to believe that there would no chance of it hitting 161 by January of 2015. If they believed there is no chance of it hitting the 161 strike price, then instead of the Call option being priced at $6.00 per 100 shares, it would be priced at less than $1.00.

So, now look at the reverse. If the price of this January 17, 2015 GLD Call option with a strike price of 161 is priced at $6.00 per 100 share contract, then this would translate into a lot of investors believe it is a good possibility that it will exceed that strike price at expiration.

If you are a long term investor who is properly diversified, then it appears that option investors believe that GLD will come back in less than two years.

In the short term, however, there is a lot of volatility for options that expire in 2013. What is going on is investors who sold Calls instead of buying calls are closing out their positions. In other words, if you SOLD a 161 GLD call and the market moved in your favor, then you close out your position by buying the 161 GLD call. This locks in the difference in price of the call.

For example, assume an investor BOUGHT a 161 GLD call that expired on April 20, 2013 for $6.00 per 100 share contract when they originally purchased it. Now, it is priced a 0.03 per 100 share contract. By closing out the position, the investor who SOLD the call would net a difference of $5.97 per 100 share contract. The investor who BOUGHT it could only get back the $0.03 per 100 share contract. Some investors win and some investors lose. In this example, the investor who bet that there was no way GLD was going to exceed 161 by April 20, 2013 was the winner.

So, now take this short term option example and notice that the price of the 100 share contract option had dropped to only $0.03. This is what happens when the market goes against the BUY side. So, to interpret this a little further, you would assume that if GLD was such a terrible investment going forward, then the January 17, 2015 Call option would also be priced really low like $0.03, but it is not. This means that there are enough investors who believe GLD will come back that the longer term premium prices for the 2015 options warrant a higher price. This further means that there is a lot of investors who believe that there is a strong "put your money where you mouth is" position for GLD coming back up in price by January 17, 2015.

I hope this makes sense.

It is never a good idea to sell on a day like today. Especially when you look into the future with options and see where the money is flowing. It is flowing to GLD coming back up in price longer term.

If the January 17, 2013 Call option was priced at $0.03, then we would have something to worry about. However, this is far from the case as of today.

Stay diversified and focused on the long term.

By the way, I am not a gold bug. I believe in prudent investment management based on a diversified strategy of passive index, low cost ETF's.