(GG) Why Gold Prices Could Fall From Here – And Two Ways to Play the Move

November 25th, 2009

by Karim Rahemtulla, Options Expert
Tuesday, November 24, 2009: Issue #1144

Of all the great investments you could have made in 2009, gold is right up there among the best of them.

The price of gold has surged this year, taking gold shares upwards with it. Readers of my Xcelerated Profits Report have rung the register with 45% profits on Goldcorp (NYSE: GG) and a triple-digit winner on Golden Star Resources (NYSE: GSS). We’re also up big on Yamana Gold (NYSE: AUY) at the moment.

All is good, right?

On the surface, perhaps. But not if you believe what the options market is saying…

Yamana Options Signal a Share Price Drop

Using Yamana as an example, the options market is betting that over the next 12 months or so, Yamana may fall from current levels of around $13 back into the single digits again.

Just take a look at the January 2011 $7.50 put options (the right to sell Yamana shares at $7.50), currently trading at $0.70 cents per contract. This means the put buyer thinks Yamana’s price will fall to $6.80 – almost 50% below current levels – in order to be in the money. The $6.80 price is derived from subtracting the price of the option from the strike price ($7.50 minus $0.70 = $6.80). This tale is similar across other gold shares, too.

These put options are expensive relative to Yamana’s share price – the result of gold prices moving sharply in previous weeks and causing the volatility in gold stocks to increase.

As a quick refresher, the price of an option is based on four major factors:

The price of the underlying shares
The options strike price
The time to expiration
The volatility of the underlying shares

Two Ways to Play Gold Prices… But Only One Viable Option

So if you’re a gold investor looking to participate in the market, what can you do to protect your profits, or buy shares at a lower price? Here are two potential ways…

If you own gold shares at the moment: Buy put options to protect your profits.
If you don’t already own gold shares: Sell put options to lock in a lower price for your shares and get some cash from the bargain, too.

However, only one of these options is viable right now – at least with Yamana anyway.

Buying puts on Yamana would be an expensive proposition. To protect yourself against a drop from current levels, it would cost you almost $3 per share. On a $13 stock, that’s more than 23% just to get in the game. Yamana would have to drop by more than $3 per share for you to start seeing any profits on the option, while negating $4 in your own profits. Way too expensive.

Here’s the alternative…

The Best Way to Buy Gold on the Cheap

When an option is too expensive to buy, you should consider selling options instead. By doing so, you receive instant cash into your account.

For example:

If you sold the Yamana January 2011 $12.50 puts, you’d receive $3.55 per contract. This means that if Yamana falls under $12.50, you’d be obligated to buy the shares. But before going into the trade, you must make sure that you not only want to own the stock, but also pick a price that you’d be comfortable paying for the shares.
However, your true cost is $8.95 ($12.50 minus $3.55 = $8.95). That’s a very attractive entry point – about 40% below the current price. If gold continues higher and gold shares follow, you still get to keep the money from selling the option – that is always yours to keep.

So, what should you do now?

My advice is two-fold…

Employ a strict trailing stop on your Yamana shares (or any gold shares you own).
Sell put options in order to rake in the huge premiums available at the moment, knowing full well that the expensive option is implying that the underlying share price will fall. By doing so, you’ll have the opportunity to buy the shares for a much lower price than current levels. And by using a trailing-stop, you’ll protect your profits in case of a decline in the shares that you already own.

Now, this is only applicable if you’re trading gold shares over the short-term. If you’re a long-term gold investor, hang tight and be ready for a volatile ride.

But if you’re planning to establish a position, then selling puts is one of the best option trading strategies you can use to get you in at a lower price… and get paid for trying!

Good investing,

Karim Rahemtulla

View original at: Investment U

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