Gold "Strangle" Looks Attractive Here

Real-time Monetary Inflation (last 12 months): 1.8%

There are always three possible trends for a market at any given time: up, down or sideways. Experienced traders appreciate the fact that markets often tread water before making substantial and sustained moves up or down.

Gold's no exception. Within its broader bull market, the yellow metal has spent a lot of time dithering. After gold's March 2008 peak, for example, bulls had to wait 20 months for a new high. In the interim, gold prices sagged to interim lows, but not so much as to break the longer-term uptrend.

Gold's recent market action and the lack of fresh price impetus seem to be setting up yet another bout of vacillation. The accumulation we've been seeing since the beginning of the month has faded into distribution as prices have sagged.

We're also seeing that weakness reflected in prices for the SPDR Gold Shares Trust (NYSE: GLD). That's piqued the interest of option traders who think a sideways market puts time on their side.

 

SPDR Gold Shares Trust

 

When you consider what an option is, it's really nothing more than the grant of time. Time for a market to move in a certain direction through a certain price point within a certain time. The buyer of the option gets the time from the seller.

Buyers, naturally, believe an option's underlying asset will move through the contract's strike price before expiration. To make money, the market must move. Call buyers must see prices rise and put buyers must see prices decline.

Option sellers, on the other hand, profit in complementary scenarios. Call sellers get to keep their premium if asset prices decline; writers of puts gain when prices rise. But sellers also make their premiums when markets-how shall I put it?-dither. Sideways markets that keep calls and puts out of the money ring the option grantors' cash registers.

December GLD calls struck at $120 were selling for $5.80 a share this morning, while December puts with a $100 strike price were bid at $5.75. Selling this pair of options-a package known as a short strangle-puts a $1,155 premium in a writer's pocket and effectively dares GLD to break out, either to the upside or the downside in the next 10 months. If gold, and by extension GLD, um, dither, the options expire worthless and the premium becomes pure profit to the seller.

Risky business? Sure. And nobody should entertain notions of selling options short without being fully cognizant of the consequence of being wrong. An upside breakout could put you uncomfortably short GLD; a plummet in GLD's price, on the other hand, could make you a buyer of a declining asset.

Still, you have to consider the odds. Right now, strangling GLD looks pretty attractive.