Description

GLD Call Option Spread

This is not a traditional value investment, but I believe it will be interesting for some, especially those that utilize LEAPS and/or are long gold.

hkup posted an excellent (and profitable) writeup on GLD almost two years ago, which would be helpful to reference.  I think the case for gold is equally compelling now, for all of the same reasons.  The last two years I have been long gold via call spreads, which has resulted in 2 excellent gains of between 2x and 3x (each time).  I think the likelihood is that the same scenario will play out this year: substantial but unspectacular increases in the price of gold.  If you agree, you can create excellent risk/rewards in this manner.  The implied vol on at-the-money, 1 year duration call options is only around 23.6%, which is too low considering the likelihood of substantial gains and the possibility of a real spike in gold prices at some point.  As has been discussed by many, Black Scholes does not seem to properly value options over longer time periods.

I like slightly in the money call options, around 1 year duration, although there is no magic to this choice.  It does push taxes into next year assuming you hold until close to expiration.  For example, the January $140 calls sell for around $28 with GLD at $160 (only $8 premium to intrinsic).  The past two years I have spread this long call position.  For example, I could sell the $200s of the same duration.  Right now, these sell for $5.50, implying a net cost (and downside) of $22.50 with upside of $60 if GLD rises to $200.  To me, this is a mispricing given gold's "value" (and with gold, by the way, I do think "persistence" is a factor for many buyers- meaning that gains of past years make future gains more likely).

There is a frustrating aspect to this trade, however: Unless you essentially hold until expiration, you will be forced to overpay to buy back the call you are short (the $200).  Vols increase as you approach expiration, so you could be sitting there next December, with GLD at $180 for example, thinking that you would like to close out but are forced to pay $2 to close out that short call when you believe it is close to worthless.  So, this year I have only purchased the long call ($140), and my strategy is to sell out-of-the-money calls, on a very short term basis (1-2 months), multiple times over the course of the year.  This allows me to take advantage of the elevated vol levels as expiry approaches, and allows me to "trade around" some of the swings in the gold market while still maintaining a long position.  I expect that I will be able to generate more than $5.50 from short sales over the course of this trade.

Of course many investors do not believe in gold as a value investment, and that is understandable.  But I do think this is the most effective way to implement a long gold outlook.  I think gold is likely to be up another 15-25% this year, and if it does I am likely to make 2-3x my money.

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