Why Bother with GLD Options?

By Brad Zigler | July 01, 2008 | 12:00 PM | 1 Comment

In late May, we ran a column titled, "Options for Options," announcing the debut of option trading on the SPDR Gold Shares (NYSE: GLD) grantor trust. Since then, we've received a fair amount of comment on gold ETF option trading, ranging from "So what?" to "That's crazy!"

Most people seem to think that gold ETFs are risky enough thankyewverymuch. Adding another layer of risk to the gold equation doesn’t seem to make much sense. There are options, however, that offer decidedly stock-like exposure together with the leverage of a derivative.

Long-term options known as LEAPS (Long-term Equity AnticiPation Securities) can be used to advantage by gold bulls in a number of ways. The simplest application relies upon the inherent leverage of options to yield more bang out of every buck tracking gold.

You can find a LEAPS call, for example, that conveys to its owner the right, but not the obligation, to purchase 100 shares of the GLD trust at $70 any time through the third week in January 2010. Keep in mind that GLD closed at $91.47 a share Friday. This option gives its owner the right to obtain GLD shares at a $21.47 discount to the market price. Mr. Market rarely gives away advantages so large, so you can expect to pay up the "in the money" amount, plus an extra premium for the 567 days remaining in the option's life. After all, time is opportunity in option land: the opportunity to go even deeper in the money.

At present, the call’s offered at $26.60 a share, or $2,660 per contract. If you wanted to buy 100 GLD shares outright, you’d have to pay $9,147. An investment that size could, instead, snag three of the LEAPS calls, allowing you to draw upon the appreciation potential of 300 GLD shares rather than just 100. At least until January 2010.

If GLD’s at $100 by the third week of January 2010, you could expect a 9.3% profit, before commission, on your ETF purchase. At that same price level, your LEAPS calls, though, would return 12.8%:

The risk/return patterns for the shares and the calls aren’t congruent, however. Losses on the call are limited to the premium paid, no matter how low GLD trades. Because of the premium, however, the call’s breakeven point on the upside is higher.

 

GLD LEAPS Call vs. Shares

The leverage of a LEAPS call can also be used as an alternative to a margined purchase of GLD shares. Suppose, for example, you’re considering purchasing 100 shares of GLD in a margin account. You’d need to put up half the cost of your shares, or $4,574, and borrow the balance of the purchase price, some $4,573, at the broker’s loan rate. Let’s say that’s 4.25% per annum.

You could, instead, purchase the $70 LEAPS call on GLD expiring in January 2010 for a $2,660 premium.

Here’s how the two strategies compare if they were held until the call expiration date:

The total risk of owning the LEAPS call, at $2,660, is less than a third of the risk associated with owning GLD shares, i.e., $9,147, themselves. The upfront cash needed to initiate the LEAPS position, as well, is 42% less that that required to open the margin purchase.

However, the cost of carrying a LEAPS call is 70% higher than that of purchasing GLD on margin. Carry costs for the margined stock position consists of interest on the funds borrowed to finance the stock purchase. The carrying costs for the LEAPS call is the time value embedded in the purchase premium. Time value is the premium paid in excess of an option’s intrinsic worth. Put another way, it’s the premium above an option’s in-the-money amount. A $70 call is $21.47 in the money when the underlying shares are trading at $91.47. The time value, then, of an option with a $26.60 premium is $5.13 a share or $513 per contract. Time value wastes away as an option approaches expiration.

Note, too, that the LEAPS’ breakeven price is $2.11 per share higher than that of the margined GLD purchase, after accounting for margin account interest and the LEAPS purchase premium.

The return obtained by the margined purchase on GLD’s move to $100, at 12%, is slightly higher purchase than the 11.3% profit achieved by the call. Pretty stock-like, that.

Of course, there’s a lot more to options than just the cursory examination offered here. More details can be obtained from the Option Industry Council, but you can get a sense from the foregoing that some options, at least, can behave very much like their underlying shares while they reduce capital commitments and overall risk.

How bothersome is that?

LEAP GLD You forgot to give the symbol for the leap option for 2010. Submitted by Anonymous (not verified) on Tue, 2008/09/09 - 11:03pm » reply |