Golden Brackets: Strangles Provide Sizable Yield

You may have seen the television commercials where movie and television actor William Devane drives home the point of spiraling national debt, framing it as an alarming reason to buy gold now. If so, you’ll more or less understand the biggest reason the majority of the U.S. public buys gold: security.

A nugget of gold is a physical manifestation of financial security. You can see it, bite it, hold it in your hand. If the market crashes, a building blows up or a currency devalues, your lump of security remains firm there, unaffected.

This is why historically, in times of fear or geopolitical strife, gold demand increases.

But gold, while technically a commodity, has many factors that make up its ultimate price. It is store of value and many consider it the ultimate currency. Thus, while a slightly more complex market to analyze than say, corn, it can be an integral part of a diversified commodities option portfolio.

Why? Because gold contracts have massive open interest, making the options very liquid and versatile for various option strategies. In addition, there is plenty of public participation in gold options, which means that there are plenty of emotional option buyers and plenty of liquidity. Perhaps most importantly, while implied volatility in gold may be slightly below par right now, longer-term volatility, combined with the factors mentioned above, means deep out-of-the-money strikes are readily available in this market.

Strangles — the simultaneous buying of an out-of-the-money put and an out-of-the-money call of the same underlying market and expiration date — and various option spreads can be used to produce a steady cash flow in this market. Expect gold to continue to pay such dividends for the foreseeable future. But for this to be true, gold will have to remain in a defined price range. While with futures options this range can be considerably wide, you must still have adequate balances in place to keep the market from surging too far in one direction.

We believe those balances are in place. They are outlined briefly below.

The Bull Case
Aside from Devane’s concerns, gold has some solid emotional firepower that should not be underestimated by the trader (although they often are by economists). Foremost of these is the surging value of the U.S. stock market. Many mainstream investors feel the market is due for a correction and has spurred diversification demand into gold. This concern was underscored by Bond King Bill Gross’s comments earlier this month that U.S. financial markets were at their most vulnerable levels since the 2008 financial crisis, calling U.S. Stocks overvalued.

Language like this, accompanied by the ever sensational headlines out of Washington’s “Russia probe,” an uptick in terror attacks on Western targets and an increasingly belligerent North Korea, has spurred public demand for gold.

Further bolstering the case for higher gold prices is the recent weakness in the U.S. dollar. Post-election euphoria boosted the U.S. dollar for some time with rosy outlooks for a business and tax friendly environment driving U.S. growth. That euphoria has given way to reality as a stalled Trump agenda, a strengthening Europe and a domestic economy that’s perhaps not quite as strong as anticipated have hurt the greenback as of late (see “Recovery hits Europe,” above).

This in turn, helps fuel speculation that the Fed will slow its pace of rate adjustment – causing all of the recent dollar bulls to scale back long positions.

A weaker dollar has historically been loosely correlated to firmer gold prices. As stated earlier, there are many ingredients in the gold price pie. But that is only the half of it.

The Bear Case
While the greenback’s breather in 2017 has given gold prices a tailwind for most of the year, the factors fueling gold’s tepid rally are more immediate term in nature.

The bear case is more macro, big picture stuff. First off, there’s inflation. Bullish views of 2017/18 inflation rates have cooled with the recent dip in the U.S. Consumer Price index.

A new CNBC survey of money managers, investment strategists and economists show respondents see inflation at 2.12% at year end, down from 2.37% in January. The expectation for 2018 was 2.28%, down from January’s 2.57%. The recent dip in the U.S. Consumer Price index has cooled talk of higher inflation. As gold is often seen as a gauge of inflation, the change in sentiment can be considered a bearish development.

Secondly, gold has a bigger picture interest rate issue. The United States was first to implement quantitative easing and was first to begin tightening rates. Europe, by contrast, waited and thus, its ascent out of recession was slower.

As it stands now, the United States is still the only major Western economy tightening rates. The rest of the world, despite recent rumblings from the Eurozone, remains in the comfortable but potentially treacherous waters of quantitative easing.

U.S. dollar bulls may have tapped the brakes this year. But it’s only because they had their foot so heavily on the gas in 2016.

Despite a few red flags in U.S. economic numbers this quarter, the Fed still bumped rates 25 basis points in June and is expected to do so another time or two this year. The United States remains and will continue to remain ahead of Europe for some time in this regard. This is not only longer term supportive for the dollar, but it will serve as an overall headwind to gold price rallies in 2017.

The plan
While shorter term factors have been supporting gold prices as of late, longer-term monetary trends should continue to keep gold prices from running away anytime soon. In fact, it is quite possible that selling in the dollar is approaching a point of exhaustion. With renewed attention to U.S. rate hikes and a potential rebound in the dollar, a corresponding correction in gold is a possibility in the second half of 2017. Just don’t expect a wash out.

These two balancing forces set up an ideal scenario for writing options strangles in the gold market, as we expect gold prices to continue to gyrate within a widely defined price range.

Self-directed investors can consider selling the April gold 1060 puts and April gold 1460 calls for a total premium of $1,100. This gives the trader a $400 window for profits (see “Strangling profits,” above).

Strangles are durable option strategies that can profit from a variety of price scenarios. Obviously, the best-case scenario is for gold to remain in a range and not challenge either strike. In this case, you simply wait for the options to expire or exit when time value drops and most of the value can be realized. If there are three weeks left until expiration and say, 70% or 80% of the premium can be realized, it is best to take profits and look for your next trade. If the market challenges one of your strikes, it is still possible to maintain a profit on one end by hedging the option at risk to being exercised. Given the balanced fundamentals in gold prices at present, slapping the “golden brackets” on this market appears to be a high probability path to yields for second half 2017.