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posted on 03 March 2016

A Second Way To Buy Gold At A Discount

by Russ Allen, Online Trading Academy Instructor

Online Trading Academy Article of the Week

In last week's article I laid out a way to use options to buy the exchange-traded fund representing gold at a discount. I said last week that there was a second way to approach the same goal, and we'll look at that here. To be clear, these methods could be used to buy any stock or exchange-traded fund at a discount, not just the one representing gold.

To recap briefly, the first suggestion was to sell (short) an out of the money put. With GLD at $118.36, as I explained it then:

"The March 114 put, with 35 days to run, could be sold for $1.40 per share ($140 per 100-share contract). Selling the put would place $140 in our brokerage account immediately. In return, we would be contractually obligated to buy 100 GLD shares at $114 per share if the option were exercised. We would need to have $11,400 in cash in our account in reserve in case that happened. If (and only if) GLD closed below $114 on the expiration on March 18, then the option would be assigned and the shares would be ours. Our net cost per share would then be $114, minus the $1.40 per share we had received for the puts - a net of $112.60."

Now for the second alternative which is similar but subtly different. In this variation we sell an in the money option put rather than an out of the money one. The effect is to buy the asset at a somewhat higher net cost but still at a discount to current price. This one has the added bonus of making more money if GLD should soar out of sight than the first method would.

Here is how it would work in this case. At the same time as before, instead of selling the $114 put at $1.40, we would have looked for a put at a higher strike price than the $118.36 then-current price. The plan here would be to intentionally have this new put assigned, and in that way acquire the stock. This would happen even if it remained fairly close to the current level and did not pull back all the way to the $114 strike price we were contemplating before. For this purpose, we could have sold the April $119 put for $4.50 per share.

Now, if GLD should remain below $119 until the option expiration the shares would be put to us. Our net cost per share would be the $119 that we would have to pay at that time; less the $4.50 that we had already received; for a net of $114.50. That was still a considerable discount compared to the current price of $118.36. We would have a higher probability of acquiring the shares because now they only had to be below $119, not $114 as before.

Our upside maximum profit in case the option was not assigned was now higher than with the $114 puts as well. Because we had collected $4.50 in premium for the put instead of just $1.40, that $4.50 would now be our profit if GLD should zoom higher. If it did, and was above the $119 strike at expiration, then the puts would not be assigned. We would not end up with the GLD shares but we would still get to keep the $4.50 per share that we had received for selling the puts. The trade-off was that with the in the money puts our loss would be greater if GLD should go down instead of up.

In summary, here is how the two short put trades stack up. In the captions below, OTM means out of the money option, and ITM means in the money option:

OTM PutITM Put
With GLD at $118.36...($114 Strke)($119 Strike)
Maximum profit if not assigned1.404.50
Net cost per share if assigned112.60114.50
Probability of assignmentLowHigh
Loss if GLD dropped to $1102.604.50

Both variations would result in a purchase of GLD at a big discount to the current price if assigned. The in-the-money option would be the more aggressive choice, with a bigger risk to the downside but a bigger payoff to the upside. It would also have a higher probability of being assigned and acquiring the shares. If we were very bullish on gold this could be a good choice.

The out of the money option would be the safer choice, risking less to make less. Which one we chose would depend on how bullish we were on gold.

As always the best thing about options is that they give you - options!

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