Gold is on a Tear Again…

Gold Coins

So the yellow metal is back on the upswing and so is the dollar. When you are buying gold, on some level you are getting short the U.S. dollar. But what if you want to remain long the dollar as well? As a result, any investment in gold itself may be tied to the dollar and its relative strength (or weakness) to other currencies, namely the euro, yen, pound, etc.

This negative correlation may theoretically reduce your potential profits, because the strong dollar negate some of gold’s rally in dollar terms The dollar represents the majority when it comes to liquid currency reserves, and the current global monetary system relies on the U.S. dollar as a reserve currency by which major transactions (gold included) are measured. This is the basic reason for this relationship.

Euro-denominated gold and its recent sharp rally have been in the news and the subject of blogs, chat and other coverage (aside from the rally in spot gold everyone is talking about).

Just yesterday, a colleague of mine on CNBC’s Fast Money, Dennis Gartman, talked about getting long gold in yen terms. On the show it seemed that everyone was baffled by his explanation of how to do this, so I thought I would share my thoughts about getting “synthetically” long gold in a dollar-neutral (vs. the euro) sort of way.

Please don’t take my words as a buy/sell/hold recommendation on Gold or any of the products mentioned. (Note: prices given as of Tuesday’s close).

One of the most popular ways for the retail trader to be long in Gold (other than the futures market itself) would be to buy the SPDR Gold Trust ETF GLD, which closed at $121 on Tuesday.

Long Calls in the Gold Trust

For options traders who want to synthesize a long position, one might choose an in-the-money call on the GLD. Let’s assume you bought 10 September 114 calls for $10.00 each. This would be an investment of $10,000 (the maximum loss in the trade) and would give you roughly 720 deltas in GLD. By taking this position, you are obviously taking a bullish position in gold itself. But let’s assume you thought the dollar would continue to strengthen against the euro. Any relative strength in the dollar might counteract natural price changes in gold unrelated to dollar changes. Because of this relationship, some traders may choose to neutralize that potential counteraction.

Balancing Out the Dollar/Gold Dichotomy

One way options traders can attempt to neutralize the impact of the dollar is to take a look at the Euros WCO ETF XDE. This is a euro/U.S. dollar ETF product offered by the NASDAQ OMX and ended yesterday’s session at $119.74.

The XDE multiplies the EUR/USD by 100 times, meaning that a half-cent move in the FX market translates to a 50-cent move in the XDE. To create a dollar-neutral, long gold trade, a trader can combine long calls in the GLD with a similar-delta long put in the XDE (perhaps something like the September 125 puts for $7.00). This trade would therefore be somewhat balanced (delta neutral and with the same time frame). I am only using these particular options as examples because they have similar deltas. Long puts also offer limited risk (up to 100% of the premium paid) compared to shorting the Euro currency or ETF.

If this hypothetical trade was put on a couple weeks ago, you would have amplified your return because of the drop in the euro combined with the rally in gold.

There are periods of time, however, when this trade may NOT offer you any amplification.

Also keep in mind that if gold moves lower and the euro begins to rally, you could wind up losing money if you are long a call in the GLD and long a put in the XDE. Remember the risk is your entire premium paid for both options. Yesterday, for instance, the GLD was down 49 cents, while the XDE was up 63 cents, making this trade a net loser on the day.

Things to Remember

Remember, there are many variables to deal with, particularly the correlation between the two ETFs. In other words, one would need to take a look at how the two indices have tended to behave with relation to one another in the past, combined with the volatility of each product. In your trade plan, you may end up adjusting the amount of calls or puts that you buy. The implied volatility of the September-dated options is about 15%, where GLD implied volatility is around 23%. The fact that both indices are around the same price may make it easier to compare the two.

Hope this helps.

Photo Credit: Jeff Belmonte

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