An alternative play for gold bulls

Key points

• There is a lot of speculation that gold is about to break out to the upside
• One danger to making a big commitment is that hype surrounding gold often turns out to be just that
• Traders who want to play the long side of gold but who a) have doubts and/or b) don't want to commit a great deal of capital can consider a position using options on ticker GLD

Trading gold via ticker GLD

The SPDR Gold Shares ETF (ticker GLD) is designed to track the price of gold bullion. At the moment, gold is threatening to break out to the upside. Plenty of pundits are calling for a decisive move higher by gold in the months ahead. This piece is not advocating a bullish outlook for gold. The purpose of this piece is merely to highlight one limited dollar risk way to play for a trader with a bullish outlook for gold.

The most straightforward approach to playing a bullish outlook for gold is to buy gold futures. However, futures trading is not for everyone and involves a degree of leverage that most individuals are not equipped to deal with. For a non-futures trader, the most straightforward approach would be to buy 100 shares of GLD. However, at its current price, near $169 a share, this would involve an outlay of $16,900. Not a small dollar commitment for a speculative position. So, let's consider an alternative using options on GLD.

Trading GLD using the out-of-the-money butterfly spread

The example trade we detail below should not be considered a recommendation. It is an educational example of one way to play the long side of gold without the capital commitment and/or risk associated with buying shares of GLD or trading gold futures. 

Our example trade involves:

• Buying 2 GLD Jun16 2023 170 calls @ $8.98
• Selling 3 GLD Jun16 2023 197 calls @ $2.09
• Buying 1 GLD Jun16 2023 224 calls @ $0.64

This strategy is referred to as a 2x3x1 out-of-the-money call butterfly spread. The figures below (courtesy of Optionsanalysis) display the particulars and risk curves (expected P/L at a given price for GLD as of four dates leading up to option expiration).

On the right-hand side of the chart below:

• The red line represents the expected $P/L for this position at a given price for GLD as of 2022-12-27
• The blue line represents the expected $P/L for this position at a given price for GLD as of 2023-02-22
• The green line represents the expected $P/L for this position at a given price for GLD as of 2023-04-20
• The black line represents the expected $P/L for this position at a given price for GLD as of 2022-06-16 (options expiration)

Things to note:

• This position gives gold 171 calendar days (almost six months) to break out to the upside
• The cost to enter - and the maximum risk - is $1,233 (or only 7.3% as much as the $16,900 needed to buy 100 shares of GLD)
• The breakeven price for this position at June 2023 expiration is $176.16 (4.2% above the current price of $169).

Let's look at what the position's Greek values tell us:

• The position starts with a Delta of 65.53. This means that it is roughly equivalent to holding 65 shares of GLD
• The position starts with a Gamma of 1.037. This means that for every $1 GLD rises are falls, the delta for this position will rise or fall by 1.037
• This position starts with a Vega of $12.87. This means that for every one-point increase or decrease in GLD options implied volatility, the position will gain $12.87 or lose $12.87 in value
• This position starts with a Theta of -$1.19. This means that this position will lose $1.19 in value each day due solely to the passage of time

Note that these Greek values can and will change as time goes by and as the price of GLD shares rises or falls. For example, note that if GLD falls in price, time decay begins to work against this trade. However, if GLD rises in price, time decay begins to work in its favor.

Position Management on the downside

This position gives gold roughly six months to stage a rally. That said, GLD must rally at some point, or this position will lose money. If GLD fails to break out and instead turns down, a trader has several choices. They can either bail out quickly and salvage as much premium as possible - possibly in hopes of establishing another position later. Or they can set a hard stop, such as the October low of $150.57. However, the position will have lost much of its value by that point.

If a trader truly believes that gold will break out to the upside sometime in the next six months, and if $1,233 is an acceptable amount of risk, it would make sense to use $150.57 as a stop-loss point and simply let the position ride unless and until the stop-loss point is hit. On the other hand, if the trader thinks gold is about to break out right now, it might make sense to bail out quickly if that breakout fails to materialize.

The bottom line: There is no correct answer. Each trader must assess their expectations and objectives and decide accordingly. 

Position Management on the upside

When to take a profit on this position is perhaps an even trickier question. A one-standard-deviation move would take GLD to roughly $191 a share. At that point, the open profit position would be between $1,390 and $2,900, depending on whether that price is hit sooner or later. Note that between roughly $178 and $197, time decay works in favor of this position. See the chart below.

Suppose GLD reaches $197 a share, and no adjustments had previously been made. In that case, it makes sense to close the position and take the available profit, as the profit potential rolls over and trends sideways to lower above that price.

Of course, there is also the possibility that GLD rallies a moderate degree and then either reaches an overbought status (via, say a high RSI reading) or begins to roll over, threatening an open profit. A trader could find themself having to decide whether to a) take a profit, b) let it ride, or c) adjust the position. The reality is that there are no hard and fast rules in this situation. The best advice is to a) trust your instincts, b) act decisively (or not all), c) do not second-guess yourself on subsequent trades if your decision this time around did not turn out to be the optimal choice.

What the research tells us…

There is no guarantee that gold is headed for a breakout and a significant rally. However, there are several choices for a trader who wants to play that potential opportunity. Futures contracts offer terrific profit potential but entail a great deal of leverage and theoretically unlimited risk. Another choice is to buy shares of GLD. This gives a trader direct exposure to gold bullion price movement. However, the shares are not cheap and can entail a significant cash outlay. Lastly, there are options strategies on ticker GLD such as the one above, that offer significant upside potential at a fraction of the cost (and/or risk) of the other two choices and with limited risk.