Oct 21

I am not a fan of gold. For those who are, are you putting your money where your mouth is? Do you think gold will be over $1250 by the end of 2010? That’s ‘only’ 21% higher than it is today. I’ll pass along a secret, odds are 4 to 1 against it happening. If you feel otherwise, that it’s a sure thing, I’ll share with you how to collect that payoff. First a disclaimer: The following involves the use of exchange traded options. I’ve not discussed these instruments before, and will be providing only a brief overview to explain a specific strategy. Don’t do it unless you understand it. Even if you do, don’t do it.

goldoptions

This is a clip of the option quotes for the GLD ETF which trades at 1/10 the price of gold. An option gives you the right but not the obligation to buy the underlying stock at the strike price you choose. For example, $1450 gives you the right to buy 100 shares (options are priced per share but trade 100 at a time) of GLD until Jan 21, 2011 for $100/share. If gold rose to $1200, your $1450 would rise to $2000. Make sense?

Now for the 4 to 1 bet: if you bought 1 option at the strike price of $115 for $950, and sold the $125 option for $710, you would be out of pocket $240. If gold closed at $1250 on Jan 21, 2011, the $115 option would be worth $1000, and the $125 option is worthless, and you’ve gotten 4 times your money. Note, if it closes any higher, the difference between the two strikes is still $1000 no matter how high it closes. Below $1150, and you’ve lost your bet. In between and you’ll get something back, $100 for every $10 dollars gold is over $1150. As I said, I don’t recommend this, it’s just a thought experiment for me. Given the choice between actually buying gold or taking a fraction of that money and placing this bet, I’ll take the bet. You can lose it all, but gold can also crash to less than half its current value. Any questions on this gamble (I don’t call this investing) please comment.

Joe

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28 Responses to “Will Gold Break $1250 by 2011?”

  1. Augustine Says:

    Au is not unlike other investments, so it’s always a bet, ultimately. In bad times, it’s not a bad investment, but then again the usual precautions still apply.

    At the moment, I think that Au is overbought, so it could come down at any moment, much like the rest of the market. I don’t know if it’ll go up to $1250 in 15 months, for I think that an inflationary pressure would be necessary for it, which is unlikely to happen in this period, as there’s too much “shadow inventory” of real-estate and commercial real-estate losses to be realized, pointing to a deflationary pressure until everything is unwound, IMHO.

  2. MoneyEnergy Says:

    There are much easier and less risky ways to invest in gold, that’s for sure. Why complicate something that doesn’t need to be complicated, I say. I think a straight play on gold through an ETF is still way less risky than using options.

  3. JOE Says:

    I threw this idea out not as a recommendation, but to show that the market is so sure that gold wolt be over $1250 in Jan ’11, it will bet you 4 to 1 against. For those who are convinced otherwise, instead of getting a 25% return, they can get a 300% return on the same move.

  4. Bearlyinvesting Says:

    I am well acquainted with the reasons to have gold, it has been very good to me so far. I can’t understand why anybody wouldn’t want to own precious metals. I am not concerned with a 1200 gold. What I am interested in are the fundamental reasons to own it. I don’t think gold is overbought, if you consider important factors:

    1. Stock market is doing well, and potentially an indicator of inflation.
    2. The dollar is tanking, and going to continue to tank.
    3. China is making moves for the door. They are telling their citizens to buy gold, and probably stop financing US credit.
    4. All currencies are inflating. That is: all central banks are printing money. They are devaluing their own currencies. Because this is a global phenomena, money is losing its value.

    From the Independent:

    “In the most profound financial change in recent Middle East history, Gulf Arabs are planning along with China, Russia, Japan and France to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.

    Secret meetings have already been held by finance ministers and central bank governors in Russia, China, Japan and Brazil to work on the scheme, which will mean that oil will no longer be priced in dollars.”

    Would love hear your thoughts!

    The plans, confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong, may help to explain the sudden rise in gold prices, but it also augurs an extraordinary transition from dollar markets within nine years. “

  5. JOE Says:

    I think it’s an archaic relic. When you look at supply/demand you see that most demand is ready to walk away at any time. Unlike most other commodities, such as oil, which has a true demand, too much of gold’s demand is based on human nature.
    Say tomorrow all paper money becomes worthless. Would you rather have an ounce of gold or a pantry stocked with 1000 cans of soup?

  6. Augustine Says:

    The fact is that Au has not appreciated relative to other currencies like the Canadian or the Australian dollars. The rise in the price of Au is not an indicative of demand, but of the devaluation of the dollar. The same can be said about the stock market, that its rise has been largely driven by the devaluation of the dollar due to Ben “Helicopter” Barnanke.

  7. Bearlyinvesting Says:

    Augustine… Perhaps I misunderstand you.
    But I say not so.
    http://www.kitco.com/
    Click on
    “Live currency charts and charts comparing $USD gold to all major currencies.”
    Take a look at the 10 year hard currency chart.

  8. Bearlyinvesting Says:

    Joe,
    I don’t mess with options at all, but I was looking at this, and it doesn’t make any sense to me.

    “For example, $1450 gives you the right to buy 100 shares (options are priced per share but trade 100 at a time) of GLD until Jan 21, 2011 for $100/share.”
    Okay, I am with you.

    “If gold rose to $1200, your $1450 would rise to $2000. Make sense?”

    Uh? How? If gold is trading at 1060.00 an ounce now, and it rises 140 dollars to 1200.00. How does that equate to the $550 jump in profit (I assume you’d have to liquidate the shares to take the profit)?

  9. JOE Says:

    Let’s stay with the GLD pricing. The $100 strike price costs $14.50 (now), if GLD was $120, a $100 option would be worth $20 at expiration. Now, multiply by the 100 shares, and the $1450 is worth $2000. This is the leverage that options offer, even more so with a strategy that I showed.

  10. Augustine Says:

    Joe,

    I was referring to the past few months and the charts at Kitco confirm that there’s a spread between the Dollar and the Pound and other currencies of about 30%. Try http://www.kitconet.com/charts/metals/gold/2a-aud-us-60d-Large.gif and you’ll see that, while Au has climbed 10% in USD, it has changed practically 0% in AUD in the last couple of months. Is it a coincidence that Au is going up primarily in “helicopter” countries?

  11. JOE Says:

    Augustine -
    I appreciate the chart you link to, but I think you were replying to BearlyInvesting, not me. Your observation is accurate, I’d like to see a bit of a longer term chart though. One going back to 1980 would be great, wasn’t the Yen at 250 to the dollar? Now 100 or so. So in Yen, gold isn’t even halfway to its old high. great store of value if you’re Japanese.

  12. Bearlyinvesting Says:

    The AUD has done extremely well against most currencies. That is interesting… I appreciate your point Augustine.
    I was under the impression that all important central banks were inflating. If I read that correctly, the AUD is up over 20% against the USD in a very short period of time. (3 months?!)

    Joe, I see your point about gold being a “non-essential” asset/commodity. The only caveat to that is that, would be that gold is also a financial instrument. We couldn’t actually use (as in your example) oil as an instrument of commerce. If money were to become valueless tomorrow would I rather have soup or gold? I’ve heard this point before, and I frankly don’t really understand it. Depends on the situation does it not? If I were in Venezuela circa 1994, I’d rather have gold, and a way to broker it internationally.

  13. Bearlyinvesting Says:

    Joe,

    Got it, thank you.

  14. Augustine Says:

    Apropos, this chart at Kitco – http://www.kitco.com/kitco-gold-index.html – shows how the recent push in Au has been largely due to the falling dollar.

  15. Bearlyinvesting Says:

    Now this seems like an even better idea to me. The fundamentals for a gold bull are still in place.

  16. Augustine Says:

    Fundamentals? The market has been running on fumes for at least 3 months…

  17. Bearlyinvesting Says:

    The fundamentals of the market are not what I am talking about. Gold is more about the continued devaluation of the USD, and the printing of money by most central banks.

  18. Augustine Says:

    Bearly,

    I understand now. However, even if the fundamentals are right, they may overshoot into overvaluation and bounce back in panic. Treat cautiously and cost average your exposure, as usually.

    Gold luck!

  19. kidgas Says:

    Now that gold is over $1250, how is this trade working out? Did it turn out like expected? Again, it is too late for me to look up all the numbers but would be curious to see a follow-up post. I am encouraged by the futures tonight with the Chinese revaluation. Hoping for a strong stock market tomorrow.

  20. JOE Says:

    The 115 strike ($1150 gold) is at $13.50 and the 125 strike, $8.50.
    The spread has moved from $240 where I made mention of it, to $500. This, as gold rose from $1034 to $1228.
    A new entrant would see a 2X return betting that gold will still close above $1250 in Jan ’11.

    Note – I am not advising either way on this trade, the original post was in reply to readers asking about Gold breaking $1250, this option spread seemed a better return for those so sure the $1250 was inevitable.

  21. Kidgas Says:

    OK, now that it’s morning I have re-read the post. It looks like a bull call spread and that right now you would have doubled your money. Now may be the time to get out since we know that gold has the potential to be quite volatile. You have maximized the profit based upon price at this time and are waiting on time decay for the rest of the profit. Not worth the risk in my opinion at this point.

  22. JOE Says:

    Yes, a Bull Spread. Curious though, you’d not be willing to hang in to double the return from here for a flat move in 6 months?

  23. Kidgas Says:

    Personally, no I would not. I am bullish on gold but not necessarily about the timing. I am looking several years out and with 6 months to go think that anything could happen.

    I am into collars and like to sell near term calls taking advantage of the rapidly declining time value as options near expiration. So, this trade is actually counter to what I would typically do.

  24. buygoldsilver.org Says:

    I was fully (100%) in when you wrote this a year ago, gold bought on 21 Oct 09 would have cost you $1050 oz, today $1320ish.

    I only wish I’d seen this the day you wrote it, I’d have taken those 4 to 1 odds and multiplied my 25% (from the gold) by them.

    next time you want to give those kind of odds against the inevitable rises still to come, please think of me and I’ll take the other side of your trade ;)

  25. JOE Says:

    Thanks for finding me and writing in. This article was the result of someone insisting that gold was still heading up, and my offering what I saw as the most profitable way to bet on his hunch. We have three months before I pat myself on the back, though. In general, I like the concept of the call spread. Your upside is quite high, a 25% move up creating a 400% return, and your downside, capped. Were gold to crash to $400, you’d have lost less, assuming you didn’t pull the same funds up.

  26. nicole Says:

    now look where it is joe

  27. Bearlyinvesting Says:

    Would have been a good bet.

  28. Bearlyinvesting Says:

    Would have been a really good bet.

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