Complex Made Simple

Gold continues to attract investor interest

Gold has fallen from its peak of $1,000 in April by roughly 10%. Since then it has hovered around the $900 mark. Gold surfed on the back of the weakened US Dollar. Overall this year gold gained 6.5%, while the dollar has fallen 6.3% against the euro, as investors usually look to gold as an alternative investment when the dollar is weak.

It is not a big surprise that in correspondence with the euro/dollar seeking direction, also gold is waiting for a next move.

Wednesday, a US Federal Reserve meeting is being scheduled concerning interest rate policy.

Gold has been under pressure as investors fear the Fed will keep borrowing costs unchanged, ending a run of seven interest-rate cuts.

Worse, in some statements Chairman Ben S. Bernanke was more hawkish because rising inflation.

This means that US borrowing costs might rise in the (near) future. However, maybe gold will profit from rising uncertainty because of market turmoil caused by the continuing credit crisis.

Precious metal contracts prosper

This year, Dubai Gold and Commodities Exchange (DGCX) prospered from increasing trades in gold and other precious metal contracts.

Total ‘year to date’ volumes touched 497,958 contracts, representing a 23% increase over the same period last year.

Year-to-date comparisons reflected a rise in volumes for gold futures at 12%, gold options averaged an enormous 575% and silver hit 153%.

Traders worldwide will closely watch the committee’s accompanying statement for clues as to their future bias towards rates.

Any sign of rate hikes could lead to a strengthening greenback and, therefore, a weakening gold price. One day before the Fed-meeting, futures contracts on the Chicago Board of Trade showed a 35% chance that the Fed will increase the target rate for overnight lending between banks by at least 25 basis points at its August meeting, down from 47% odds a week ago.

Recently reports showed consumer confidence dropped to a 16-year low and house prices plunged in April. In other words, any rate increase could hurt the US economy further.

Investors who are long on gold might partially protect their position by selling calls or buying put options. The biggest gold options market is the (electronic) Chicago Board of Trade.

Going long on gold

Options can also be traded at the DGCX. Investors who are interested in contract specifications are recommended to consult the DGCX website

For the sake of simplicity and to give you an idea, I will provide as an example the current quotes of the ECBOT, 11 hrs GMT. Gold August future (ZG) contract $887.50.

Bid-Ask
900 Call 17.80-21.90
905 Call 15.90-20.10
910 Call 14.20-18.40
920 Call 12.70-16.80
925 Call 11.40-15.40
930 Call 10.00-14.10
935 Call 7.80-11.90
940 Call 6.90-11.00
945 Call 6.10-10.10
950 Call 5.30- 9.30

The higher the strike price, the ‘cheaper’ the premium.

In other words, when being long on 1 gold [email protected] an investor might sell 1 contract 930 Call Aug 12.50. Thus receiving $1,250.

If the gold future expires in August at or below $930. The premium received can be cashed in. If gold rises above $930, your futures contract will be assigned.

In my example, the maximum profit will be: 930-887.50= 42.50*100= +$4,250 (profit with the future) + 1,250 extra for the premium received: Total $5,500.

Beware that the cushion is ‘just’ $12.50 per contract. So at expiration, the break-even level will be $875. Below that level, every dollarpoint drop will result in a loss of $100 per point per contract. The risk remains the downside.

See also:
Compiling a summer portfolio of precious metal assets
World gold trade focuses on Dubai