Gold Starting to Look More Precious

"It's like all shiny and stuff."
-- anonymous 13-year-old Inca upon discovering a gold nugget.

I've always been skeptical about the soundness of gold as an investment. I dismissed its marvelous 25% gain in 2002 as simply the byproduct of investors' disgust with stocks, I questioned the sanity and sustainability of the prewar price run to $380 an ounce in February, and was asking "Where's your fundamentals now?" when the dissipation of the war premium sent prices tumbling some 16% to $320 by April.

But gold's recent rally back to $370 this past month has caused me to put aside my prejudice and concede that the yellow metal might actually be in the early stages of a structural bull market. Despite all the talk of deflation, a weak dollar has actually helped support gold prices. Because gold is dollar-denominated, other currencies, like the surging euro, are getting more bang for their investment when buying gold.

A Very Big Picture

From a technical analysis perspective, the turning point in gold occurred in May 2002 when gold crossed $320, breaking a 15-year downtrend. The chart below also shows that gold has emerged from four years of consolidation (1998-2001) by putting in a rounded bottom. This formation, as opposed to a sharp spike, usually supplies a solid foundation to build future gains.

The fact that gold held support at $320 and staged an impressive rally leads me to believe gold prices will hold recent gains and even trend higher over the next 12 to 18 months. Given the large time frame and the realization that gold won't be charging up in a straight line, a decline and retest of $320 -- or even $300 -- is entirely possible but doesn't change the thesis that gold is just midway into a multiyear advance.


10-Year Gold ($USD)
*Based on New York close, 19-day moving average.
Source:www.kitco.com

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.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to Steve Smith.

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