Leverage the Gold Rush with GLD Call Options

Portfolio diversification isn’t just about spreading out risk to different asset classes, industry groups and sectors. Proper diversification involves implementing the right strategies that benefit from the current market environment; in other words, adapting to our surroundings.

The best traders adapt to what the market is doing. We can’t control the direction of the market, but we can control how we react to what the market gives us.

A renewed upward trend in gold has the shiny metal breaking out of a long-term consolidation phase, hovering at an all-time high. Typically seen as a safe haven in times of uncertainty, gold’s recent rise comes as we near the beginning of the next easing cycle with the Fed set to cut interest rates later this year.

The U.S. dollar went off the gold standard in 1971, and despite some short-term periods of strength, the dollar has been in a long-term downtrend ever since. The U.S. is the world’s largest debtor nation. As U.S. debt and deficits continue to balloon, they exert downward pressure on the dollar.

Gold and the dollar normally move in opposite directions; this inverse relationship is vital to understand. Pictured below is a nearly decade-long stretch in the early 2000s where we can see this relationship clearly. The metal widely outperformed other asset classes (including stocks) over this timeframe.

StockCharts
Image Source: StockCharts

Gold protects investors from a falling dollar and can help us guard our wealth and maintain purchasing power as the long-term slide in the dollar continues. This dynamic is why gold has been known as a store of value and safe haven against the erosion of fiat currencies.

Gold Breaks Out of Long-Term Level

Shifting to the present, a falling dollar now presents a major tailwind for gold prices moving forward. Gold is currently undergoing a major breakout, surpassing its former all-time high from August 2020:

StockCharts
Image Source: StockCharts

Central banks are scooping up gold at the fastest pace since the 1960s. The world’s central banks snapped up 290 tons of gold in the first quarter of this year, which was the strongest start to any year on record according to a recent report from the World Gold Council.

It’s a sign that many nations are keen to diversify their reserves away from the dollar. This theme should exert further downward pressure on the greenback. With interest rates set to decline from here, the stage is set for gold to have another multi-year bullish run.

Option Essentials

Before we analyze today’s trade, let’s review some option fundamentals as a refresher. My mantra when it comes to option investing is ‘keep it simple.’ There is no need to worry about complex mathematical formulas or equations. Over the years I’ve found that the more complicated a strategy is, the less likely it is to work over the long run. Our aim is to utilize a strategy that is easy to follow and has a long history of profitability.

Options are standardized contracts that give the buyer the right – but not the obligation – to buy or sell the underlying stock at a fixed price which is known as the strike price. A call option gives the buyer the right to buy a stock, fund, or index, while a put option gives the buyer the right to sell the same. The investor who purchases an option, whether a put or call, is the option buyer, while the investor who sells a put or call is the seller or writer.

These contracts are valid for a specific period of time which ends on expiration day. There are weekly options, monthly options, and even LEAPS options which are longer-term options that have an expiration date of greater than one year.

Options consist of time value and intrinsic value. In-the-money options consist of both components. At-the-money and out-of-the-money options consist only of time value. At options expiration, options lose all time value.

Below we’re going to explore a call option purchase strategy. Purchasing a call option is bullish, with the goal to sell it at a higher price than we paid. The value of the call option moves up as the price of the underlying security increases.

Multiply Your Gold Returns

As we’ve seen, gold is in a price uptrend and is a good candidate for a call option purchase. When done correctly, trading options provides huge profit opportunities with limited risk.

In today’s trade, we’re going to target options on the SPDR Gold ETF GLD. Specifically, we’ll use the July 19th expiration date and the 175-strike price. Purchasing this option gives us the right, but not the obligation, to buy 100 shares of the GLD ETF at 175 on or before July 19th, which is a bit over 2 months from now.

The table below displays the risk/reward profile for this trade. The GLD ETF is currently trading at 217.6 (orange box). We are purchasing 1 July 19 175-strike call at 44.2 points, which is the option premium. Since options account for 100 shares of the underlying stock, the total cost for this call option trade is $4,420 as we can see in the yellow highlighted box.

Zacks Investment Research
Image Source: Zacks Investment Research

The top (blue) row shows the performance of the GLD ETF based on different percentage scenarios at expiration. The bottom (purple) row shows the corresponding percentage return for our call option trade. We can see that if GLD remains flat, this trade would encounter a minor loss of 3.6%. If GLD moves up 5%, this trade will realize a 21% profit. If GLD advances 15%, we would realize a 70.2% profit.

This illustration shows the inherent leverage that options provide. An ETF investor who bought 100 shares of the GLD ETF would have to contribute $21,760, which is a much bigger investment. A 15% increase in the ETF price would yield a $3,264 profit.

On the other hand, in this example the option investor only needs to contribute $4,420 to control the same amount of underlying GLD shares. A 15% move in the GLD ETF would net a $3,104 profit – a nearly identical profit amount with only about one-fifth of the investment!

Also note that this option contains relatively little time value. The 1.6 points worth of time value (red box) equate to just 0.7% of the underlying ETF price. A good way to manage risk when buying call options is to minimize time value and maximize intrinsic value, as time value decays rapidly in the days leading up to option expiration.

Bottom Line

As the U.S. dollar resumes its long-term downward trajectory, the stage is now set for gold to witness a multi-year bull run. Gold could very well be in store for a period of outperformance, similar to the 2001-2011 decade.

A great way to take advantage of this move is via low-risk call options on the SPDR Gold ETF. This allows us to leverage gold returns with the power of options. Be sure to keep track of the shiny metal’s ascent as conditions appear ripe for it to continue.

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SPDR Gold Shares (GLD): ETF Research Reports

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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