An interesting asset to trade the past month has been gold, which is interesting because it sometimes behaves as a risk asset, and sometimes as a defensive risk-off asset. After selling off for much of December gold caught a bid on Dec. 31st as the market rallied ahead of a deal, and then continued its rally yesterday to end the week up 1.8% as of yesterday's close. This sudden strength was welcomed by option traders, many of whom took the opportunity to sell calls against long positions. The biggest trade of the day involved selling 3,000 Jan. 167 GLD calls for $0.54 against 300,000 shares. This is a bullish position that expects GLD to rise with a price target of 167 (2.2% higher) at January expiration in 15 days.
This strategy, known as a covered call or buy-write, is a popular way to reduce risk and volatility while also creating a stream of income from the option premiums. On a volatile asset like gold that has zero yield, the covered call strategy can substantially enhance long term returns and is my preferred way of owning gold.
The key to implementing a successfully buy-write strategy is selling calls that maximize yield from option premium without limiting upside gains from the underlying asset. To do this I employ a macro-economic model that uses gold's correlation to factors like bond yields and the unemployment rate. I use this to pick my price targets for gold, which is where I sell a call. Currently my model suggests that there is more downside for gold in the near term, though I believe gold's long term bullish fundamentals are still firmly in place.
Many people have been perplexed by gold's price action in December. Rising uncertainty, central bank easing, and a risk-off mentality for much of the month could have been expected to push gold higher. But instead gold sold off and the Euro rallied. I interpreted this as positioning ahead of an expected fiscal cliff deal. With the BOJ, ECB, and Fed committed to removing much of the tail risk in the world's biggest markets I have seen flows out of gold and into assets like European high yield credit. This is explains the strength in the Euro and weakness in gold. But gold's rally the past few days with stocks and high yield credit is not consistent with this hypothesis and tells me the rally in gold might have been overdone. This makes it a great opportunity to sell calls in GLD to reduce downside risk on long positions.
By collecting $0.54 of premium this trader has essentially reduced his cost basis and breakeven in GLD by that amount. The call sale can also been seen to generate yield (1.3% annualized), which is not much because the call is a few percent out of the money and therefore allows the position the opportunity to profit if gold runs higher in January. I would prefer to be short a strike that is closer to the money which will reduce upside potential but will also increase yield and limit more downside risk.
The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.