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Constructing the Gold Strangle

Gold has hung around technical resistance of about $1,160 but has been unable to break it; I feel we could see a dramatic move in either direction.
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The June gold futures contract is down $8.40 to $1,151.90; it has struggled in recent sessions around the $1,160 mark, which also happens to be the highs for 2010 made back in January. Clearly this area is offering some solid technical resistance.

We have also seen a "decoupling " of the relationship between gold and the dollar recently. In many sessions we have seen both trading higher. Typically, gold will trade higher on a weaker dollar and vice versa. A weaker greenback makes gold and other commodities cheaper for foreign buyers. This break in the relationship I feel is a bullish development. I, however, always want to cover my bases in case my analysis is wrong.

Because gold has hung around technical resistance around $1,160 but has been unable to break it, I feel we could see a dramatic move in either direction. Perhaps the bulls throw in the towel and we see a decent correction. On the other hand, perhaps the bulls are finally able to break through this plateau in which case we could see a dramatic rally higher on stop running. Volatility has been fairly low recently so a strangle would be a suitable position for this situation.

Here's how to construct it.

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Purchase to open the June 1,100/1,200 strangle. This means simultaneously purchasing the 1100 put and the 1200 call for June. These options both expire on May 25, giving the position 39 days to work. Look to pay about $1,400 for this position. Assuming commissions and fees not exceeding $50 a contract, this position would cost a total of about $1,500.

Since this position is being purchased, the maximum an investor can lose is the amount paid for the position -- in this case $1500 including commissions and fees. The position can profit in two ways. First, if there is a dramatic increase in volatility the position can profit if the option prices all become inflated due to increased volatility. Second, if the market makes a dramatic move in either direction the hope is that the magnitude of the move will be sufficient to not only cover the cost of the strangle but potentially provide a profit as well.

Because the position is costing $1,500, the break-evens on the position are as follows: Because we purchased the 1100 put, gold would need to be at $1,085 at expiration to break even. Below $1,085 is in the profit zone. Likewise, on the top side, since we purchased the 1200 call, the break-even would be $1,215. Anything above that would be in the profit zone. Once more, should gold stay stagnant or not reach the break-even points on or before expiration, the maximum loss suffered is $1,500.

Matt Zeman is a principal with Lasalle Futures Group and chief market strategist for Time Means Money.Com.