With all the hoopla of the upcoming U.S. presidential election, worries over the economy, and the possibility of rising interest rates, it’s not a surprise to see gold moving back and forth as it has been over the past several months. For investors who use options, profits may be possible without having to correctly guess the direction of the next move.
There are two keys—one technical and the other option related—to implementing a “non-directional” option trade, like a straddle or a strangle: (1) Identifying areas of consolidation on the chart, and (2) low volatility for the options.
How “Neutral” Option Strategies Work
Think of price consolidation like a spring being compressed. It can give way to bigger moves—in either direction—that can make certain option strategies profitable. But how much movement is needed, and how soon the moves need to happen, are two questions better answered once an option strategy is chosen.
Two common non-directional option strategies that are designed to profit if the underlying makes a significant move, regardless of which direction, are the straddle and the strangle. They’re very similar strategies, almost cousins. The crux of each strategy is buying a call to profit if the underlying moves up, and buying a put to profit if it goes down. The options are always in the same expiration period. The difference is that the straddle buys the options at the same strike, typically at the money (ATM), while the strangle buys options that are out of the money.
Depending on the direction and the size of the move the underlying takes, one option will profit while the other loses. But with a sizable move, the winning option can sometimes outpace the losses of the other contract, resulting in a net win.
Here is an example using options on CME Group's COMEX gold futures, which have a contract size of 100 troy ounces. Let’s say a near-term gold futures contract is trading around $1340, and you can buy the one-month 1340 call for $21, and the 1340 put for $20, to make up the ATM straddle for a net cost of $41. Since the contract size is 100 troy ounces, the initial outlay is $4100.
Let's say that over the next two weeks, gold moves higher by $60 to $1,400. Now the call option is valued at $65 and the put is worth $5. The put option lost $15, but the call more than made up for that with a profit of $44, for a net profit of $29 times the contract size, or $2900. That’s a 71% return on the initial investment of $4100.
Of course, if gold futures remained at $1340 until expiration, but the call and put would expire worthless, and you would have lost your entire $4100.
Implied Volatility and Gamma
What are the risks of buying two options this way? One risk is buying options that are simply too expensive, relatively speaking. That means you may want to avoid options where the implied volatility is not in the low part of its yearly range. Take a look at figure 1, which is a chart of gold futures. At the bottom of the chart is the implied volatility of the options on gold futures. Options in time frame A are quite expensive, which means a straddle or strangle could quickly lose value if volatility drops. Like it did.
In time frame B, a similar straddle or strangle would be much cheaper to buy, and wouldn’t have as much risk of losing value from the implied volatility dropping. As an analogy, consider the price of real estate. Sometimes the market heats up and buying property at nose-bleed levels is ill-advised. That’s not to say that it might not be profitable in the end. Just be aware of the relative cost of your trade.
Also keep in mind multiple-leg option strategies such as these can entail substantial transaction costs, including multiple commissions, which will impact any potential returns.
Take a look at the periods of price consolidation on the chart—areas where downtrends and uptrends come together. At these junctures, something’s got to give. Of course, the result might be a very small move that doesn’t produce profits in the option strategy, but that’s why keying in on cheap implied volatility is so important. If the underlying does move, then you should be set up to potentially take advantage of it.
Selecting a trade that’s closer to expiration harnesses something called “gamma.” It’s what gives the “winning” option the ability not just to cover the losing option, but also to generate an overall profit. But it comes at the cost of daily decay, and that’s why timing can be so important. If the consolidation turns into a flat-lining chart, you should consider closing the trade and moving on.
As with all option trades, a trade plan is important. On these types of strategies, which naturally involve higher-priced trades, some traders cut losses at 25% while looking to take profits at 50% or higher. So you may want to pull out your charts and start watching gold. You may not like the news that’s driving the metal back and forth, but you might be happy with the trading opportunities it can provide.
Futures and futures options trading is speculative, and is not suitable for all investors. Please read the Risk Disclosure for Futures and Options prior to trading futures products.
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