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Options Strategy: Golden Opportunity in Metal Market Volatility

February 27, 2015
Options Strategy: Golden Opportunity in Metal Market Volatility

Gold prices got off to a strong start in 2015, rallying as much as 15% from November lows to briefly climb above $1,300 an ounce in January and touching the highest levels since late last summer, based on the futures market.

Volatility in gold, as measured by the CBOE/COMEX Gold Volatility Index (GVX), surged (see figure 1) as the sharp slump in crude oil reverberated across commodity markets.

For options traders, such situations can present directional opportunities to play support or resistance or to potentially capitalize on heightened volatility by selling premium. For example, consider high-probability, short-term income trades that combine a pop higher in options prices with simple chart support and resistance.

Say an optionable, gold-based stock, exchange-traded fund, or index trading around $100 has support at $92 and resistance at $108. An option trader could take a couple different approaches, such as using support/resistance to choose strikes for an iron condor strategy.

Gold Volatility Index for January 2015

FIGURE 1: GOLD MINING. In mid-January, the CBOE/COMEX Gold Volatility Index, or GVX, surged above 22 (yellow arrow) to reach a 15-month high. Source: TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results or success.

Iron Condor

An iron condor is composed of four different options contracts. It combines a short out-of-the-money (OTM) put spread with a short OTM call spread. Ideally, the trader keeps the combined premium from selling both spreads, less transaction costs. This can happen if the underlying at expiration remains above the short put strike, yet below the short call strike. In that case, all of the options would expire worthless.

Looking at the short put side of the trade, using options with 30 days until expiration, you could sell a 92 put, hoping that support holds there. Or, for a slightly safer trade, sell the 90 put since it’s about 10% out of the money. For the call, you could sell a 108 strike at resistance, or go 10% out of the money and sell the 110 call.

One trade isn’t necessarily better than the other. Selling the 92 put and 108 call will bring in a higher premium, but at the risk of being closer to the underlying. The 90 put and 110 call are further out of the money, but will bring in less cash.

However, if the underlying security moves beyond those strike prices at expiration, the position will start moving against you. The downside breakeven point is the short put strike minus the net premium collected from the sale of the iron condor. If the underlying goes higher, it’s the short call strike plus the amount of the premium, keeping in mind the transaction costs.

To hedge against the risk of too much movement, a trader might buy a put that’s further out of the money than the put that was sold, and buy a call that’s further out of the money. These long options limit the risk of the trade to the difference between the strike prices less the premium collected, and transaction costs, which are an important consideration, especially in a four-legged strategy.

Directional Plays

Support and resistance help the "technical" trader pick strikes, but are also sometimes used to help some speculators time entries.

For example, if gold is holding at a support level, and you have a hunch it’s going to move higher, you might consider selling a put spread that’s right at the money and collect a higher premium, versus selling something that’s further out of the money.

For such a position to work in your favor, the underlying price typically must rise, or at least not drop much, since the short strike is right where the underlying is. Conversely, if the underlying price drops, your position could work against you. This makes your choice much more of a directional play. But there’s a higher net premium to collect compared to the iron condor.

Either way, higher options prices can mean more volatility and risk, but also choices worth considering.

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