Gold Starting to Look More Precious

The pullback this week to $360 has alleviated a slightly overbought condition and offers a good place to start building a bullish position. Given the surging stock market and possible stabilization of the dollar, investors are no longer scrambling into the safe haven of gold. A period of consolidation would be welcome if gold is to resume its climb and eventually challenge the major resistance found around the $400-to-$415 level.

Using Time and Patience

One appropriate option strategy that aligns with the view that gold prices will enjoy a slow, steady stepladder rise over the next year or two is a call calendar spread.

A bullish calendar spread is constructed by purchasing a long-dated call and simultaneously selling a call with the same strike but with less time remaining until expiration. In other words, the lifespan of the long calls is greater than the ones you've shorted. The rationale to this strategy is to use the sale price of the near-term call to reduce the cost of the purchased long-dated call. While initially the two calls are essentially offsetting positions, meaning you don't stand to make or lose much money in the short term, the position becomes increasingly bullish over time.

Calendar spreads make use of the fact that an options time premium decays at an accelerated rate as the expiration date approaches -- this is defined as an option's theta. The selling of the front- or near-term month can be repeated several times through several expiration months to eventually bring the cost of the long call down to zero. One would then be holding a risk-free, or "free," position.

Here's an example: On Wednesday, with the July futures gold contract trading at $362, one could sell the July 375 call for about $4 while simultaneously buying a February '04 375 call for around $16, creating a calendar spread with an initial cost of $12. It should be pointed out that the February LEAP call price is based on the February futures gold price, which is currently trading at a $3 premium ($365) over July futures.

If we assume gold prices will stay at current levels, one would need to roll the short position three more times to create a debit-free position. That would mean that by October, the long February '04 call will be completely paid for and you can now hold it risk-free for the four months remaining in the life of the contract. Profits would accrue as gold trades above $375 before the February expiration.

The time frame and relative bullishness of this strategy can be adjusted by using different strike prices and expiration dates. One could move out to another year and February '05 calls with a $400 strike, which would provide more time and flexibility.

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