As prudent, astute investors, I’m sure you have been watching this significant sell-off in the Precious Metals sector. This sell off initiated from its peak at $1,920.80 in September 2011 and has been spiraling down ever since. If you bought or purchased Gold coins or bullion from 2010 to as recent as last month, you’re likely underwater. Now you have a depreciating asset and have been depreciating for the last 3 years. Ironically, the person who sold you this bullion probably didn’t teach you how to manage downside risk. As a perpetual Bull on Gold, I understand how to manage risk and try to convey this to my clients. I’m honestly a bit surprised the strategy that I’m about to teach really isn’t discussed more often. Furthermore, how many of these “market specialists” ever really provide clear instruction and clean-cut specifics on managing risk? I’ve searched the web for educational articles on managing risk in metals and I’ve not yet found it. Still, these “market specialists” call themselves experts.
Not the End
Despite some prognosticators warnings, the end of the world is not nigh. There are some strategies you can use to help manage your downside risk. One strategy I hardly see being discussed, although it may take some effort to learn and conceptualize, is options – more specifically Gold Options. This strategy can potentially be the insurance you have been looking for to help offset some risks associated with owning Precious Metals. Options can be used as a piece of insurance, for the “What if”, and if the Gold market should drop precociously against your physical precious metal’s holdings.
Two Main Factors to Consider When Buying Gold Options
The options matrix below is what I will use for this example. It has an expiration of January 28th, 2014. Keep in mind that as more time expires, the price of options increases. For example, if I purchased March 2014 expiration, these options would cost significantly more because you’re purchasing more time. Just remember that time = money. Furthermore, once you purchase any option you also have to consider “time decay”. Time decay occurs when the market doesn’t move in your favor, and as a result the option premium value declines in value, which in turn creates a loss.
The strike price is the price where the option can be exercised. For instance, if you purchase a 1200 Put for $1,000 (10pts), technically you wouldn’t be “In the Money” until $1,190 or lower. At expiration, your option will turn into an outright futures contract short 100oz from $1,200. Displayed in the matrix below, you can see the strike prices move in $5.00 increments. Strike prices closer to current market will be more expensive than those further out of the money.
Please note the following example in the matrix below:
- 1235 Put ask is 32.4X100=$3,240 versus the 1190 Put ask which is 17X100=$1,700.
All you do is take the ask points and multiply by 100 (100oz) to know what your exact Options Put Price will be.
Now remember when buying/purchasing options, you only risk what you pay. There are no margin calls.
Buying Put Options
What is a put option? A put option is just another device to go short, which means you think the market is going down. You only risk what you pay for the option; therefore, your risk is limited to the purchasing value.
For example, you can purchase a plain gold option put. Imagine for a second that it’s an insurance policy you hope you don’t have to use to protect your physical position. However, if you do buy the gold option put, you will be thankful you did. As detailed below, we have different strike prices. White area indicates “out of the money” and highlighted yellow indicates “in the money”. For this example, we will only stick with “out of the money” options due to their lower cost basis.
Buying a Bear Spread
In this strategy, we will be limiting our profit potential, but paying less. In the first leg of this spread we’ll purchase and in the second leg we’ll be selling. Using the options matrix above, let’s buy a 1230 put strike for 30.4X100=$3,040, then simultaneously sell an 1190 put strike for 16.3X100=$1,630. The entire spread will cost $3,040-$1,630=$1,410 minus fees and commissions. So instead of paying $3,040, you are only actually paying $1,410. However, with this strategy you will limit your profit potential because we sold an 1190 put, which will work against us as the market goes down. Thus, at most we look to profit 25.9 (40-14.2) or $2,590, plus any deductions we incur for fees or commissions. Theoretically, you’re not profiting compared to your physical position – you’re actually only hedging and managing risk.
When to use: If you think the market will go down and there exists limited downside potential. Bear spreads present a good opportunity for those that want to be in the market, but have bearish expectations.
The best way to learn these option strategies is to get involved in the markets by downloading our flagship software dt Pro and setting up a paper trading account, so that you ease your way into the markets. Once you’ve established a paper trading account you can study the options price/premium in relation to the current market price as it goes up or down. Once you’ve gotten your feet wet with paper trading, you can begin to understand how the markets operate and what strategies work best to manage your risk capital. Remember that these markets can be very difficult and risky, and getting started is often even tougher, but if it was easy everyone would be doing it. So, yes, this will take a bit of work. However, once you understand the fundamentals and integrate the strategies listed above, these techniques can be invaluable assets to manage your downside risk! Don’t forget though that one of the most underused assets these days is good experience, which you’ll find with many Series 3 licensed brokers. A Series 3 broker, such as me, understands risks, and understands how to teach and manage strategies for my clients. I have no doubt that I can prove to you that there is a big difference between a licensed Series 3 broker and some guy proclaiming to be a market expert!
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