by Lee Lowell, Stock and Commodity Option Specialist
Tuesday, July 6, 2010: Issue #1295
It’s one of the most valuable and most actively traded assets on the planet.
It boasts great intraday trading ranges, with tons of liquidity, which makes it easy to enter and exit and very fair prices.
And with the stock market’s recent jump in volatility and sharp declines, it’s the asset of choice for many people seeking some shelter from the storm.
I am, of course, talking about gold.
And the question I’m going to address today is simply this: What’s the best way for you to invest in it?
Why You Need Gold in Your Portfolio
Since the stock market hit an 18-month high back in April, it’s trended lower. And on several days, we’ve seen all-out chaos and panic – for example, when the “flash crash” sent the Dow tumbling by 1,000 points in just a few minutes.
As the market has stumbled through the spring and summer, gold has moved higher, as investors hunt for protection from the volatility.
Gold should make up a part of your portfolio anyway but, with the market’s erratic behavior expected to continue, it’s even more important to have exposure to some gold.
One of the best ways to achieve that is by selling naked put options. Sounds sexy – and it is!
Buy Gold for $100 With Put Options
Now that we’ve decided to add gold to our portfolio, how about we decide the price at which we’d like to buy it? Not only that, how about we grab some instant cash from the deal, too?
Sounds like a no-brainer, right?
Even better… with gold having pulled back by about $60 per ounce over the past few days, this dip could represent an excellent time to buy.
Okay, so our first job is to decide what level we’re interested in buying gold. Then we just need to sell put options at the corresponding price (known as the “strike price”).
To make life easy, we’ll concentrate on the exchange-traded fund that tracks the price of gold futures contracts on the COMEX in New York – the SPDR Gold Trust (NYSE: GLD). One of the other benefits that GLD has is that it trades at about one-tenth the size of the underlying futures contract, making it viable for many smaller, everyday investors.
As an ETF, GLD, trades just like a regular stock on the NYSE. It’s currently trading for about $116.50 per share and when it comes to picking the price you want to pay for it, there are plenty of choices available.
For example, you could base it on the 200-day moving average line, which shows support at $110. That would be a nice $6.50 discount. But what if you want to go even lower and buy at $100 per share?
In this case, we could sell the December 2010 GLD $100 put options for about $2 per contract. Because there are 100 shares in each contract, we’d get an instant $200 for making the trade, based on selling one contract (100 shares). If you feel like buying 1,000 GLD shares, you could sell 10 option contracts, dumping a quick $2,000 into your account.
So what does that do for us?
Get Gold At the Price You Want… And Get Cash, Too
Simply put, it means we’re now obligated to buy GLD for $100 if it drops to that price by expiration in December. And for that obligation, we collect cash.
Sounds like free money, right? Well, it is – as long as you’re comfortable buying the corresponding number of GLD shares at your chosen level. So with GLD currently at $116.50, you’d be contracting yourself to buy it at $100 – a $16.50 per share discount.
What’s the catch? Not much, except that the price of GLD could drop lower than $100 per share after we’ve obligated ourselves to buy it at $100. But that’s the risk with any investment – the price can go lower.
However, if you’re comfortable buying GLD for $100 and know how to manage a stock position, then it could be worth your while to have someone give you instant money in return for having the chance to buy a stock at a much cheaper level than its current price.
Your Six-Step Put-Sell Trade Checklist
Before you execute a put-sell trade like the one above, you need to be aware of a few important things…
- You’re selling put options as the initial transaction, not buying them.
- For the duration of the trade, your broker will ask you to keep a portion of the total cost for the shares available, in case you’re obligated to buy them. As such, your options trading account will need to have margin capabilities.
- Whatever strike price you sell put options for, that will be your maximum profit potential at first.
- In order to actually purchase the underlying shares at your chosen price, the stock must close below that level on expiration day. So in our GLD example, the stock must close below $100 per share on expiration day in order to receive your shares. And you must have the cash to pay for the shares in full at that time.
- If the stock you choose closes above your strike price level on expiration day, you don’t get to buy the shares. But you do keep the initial cash you received. At that point, the trade expires.
- Remember that whatever stock you choose can drop below the price at which you buy it, so make sure you have a risk management plan in place. In addition, you can always buy back the options you sold before expiration if you want to lock in a profit.
In terms of receiving passive income, selling put option contracts can be a great way to generate income throughout the year.
When you sell at levels significantly lower than the current price of your chosen stock, the chances are high that you won’t have to buy the stock. In fact, up to 90% of the time, the options simply expire. So while this means you won’t get to buy the stock at your desired price, you do get to keep the cash over and over again.
P.S. The GLD trade above is just an example of how a put-sell trade works and not a specific recommendation.