Gold options point to $1,200

By Frank Tang
Reuters
Friday, July 25, 2008

http://www.reuters.com/article/hotStocksNews/idUSN2535920220080725

NEW YORK -- Heavy bets in deep out-of-the-money calls and other bullish plays in the gold options market indicate that bullion has a shot at rallying to an all-time peak of $1,200 an ounce by the end of the year.

Gold has soared furiously -- a few years ago the metal was trading at $250 an ounce -- as investors poured into the market due to inflation fears, a weakened dollar, and market turmoil.

"There are a lot of people who think that by the end of the year we'll be trading $1,200 to $1,500. They are not very expensive options, so people are buying them," said John Bilello, COMEX gold options floor trader.

Bilello said that many option investors were currently adjusting positions after gold's sharp fall but he saw recent strong volume of December $1,000 calls, bull call spreads between $1,200 and $1,300, and the selling of put options -- all of which are betting that gold will rise further.

A bull call spread involves buying a lower strike price call and selling a higher strike price call, and profits are maximized when prices rise above the higher strike price.

Option traders saw strong interest in the $1,200 December calls and other higher strike prices because they offered an affordable way for individuals to invest in gold's upside potential.

In addition, these out-of-the-money call options are priced sharply below those of the near-the-money ones -- a sign that the price volatility of gold will likely stay high in the near term.

An option is "out of the money" when the exercise price of a call -- which gives the buyer the right but not the obligation to buy gold futures -- exceeds the current price of the underlying gold contract.

"Option strategies and option positions do reflect the bullish outlook for the gold market. The general view is that gold does have an upside bias despite the setback in the last couple of days," said Bill O'Neill, managing partner of New Jersey-based commodity firm LOGIC Advisors.

Gold has lost $40 so far this week due to tumbling oil and a stronger dollar, after moving within striking distance of the $1,000 mark last week.

On Friday both the U.S. gold futures for August delivery and spot gold traded at $925 an ounce. Gold scaled a record-high $1,030.80 on March 17.

COMEX December $1,200 calls currently have 30,000 lots of open interest, by far the most popular among all the different strike prices. The second-highest was the $1,000 calls with 15,144 lots, followed by the $1,050 calls with 12,637 lots.

George Gero, vice president of RBC Capital Markets Global Futures in New York, said that the gold options market was a bullish signal because investors wanted to be long further out in strike prices.

... Rising volatility

Investing in call spreads substantially reduces costs but also lowers the upside, and the strategy was very popular for gold options investors, said Rob Kurzatkowski, futures analyst with optionsXpress in Chicago.

Kurzatkowski said many small speculative traders who cannot afford the more expensive near-the-money calls or the 100-ounce gold futures could turn to the deep out-of-the-money calls for gold investment.

"They are hoping to catch a bit of a move on their investment. So the higher open interest in strike prices out there ... is an affordable way for them to participate in the market," Kurzatkowski said.

On Friday a single lot of December $1,200 call option costs $7.30, compared with $56.10 of the on-the-money December $925 call. The difference is due to gold's high implied volatility, which measures the expected magnitude of gold futures price movement given an option price.

Kurzatkowski said that gold's current implied volatility was about 36, sharply above the long-term average in the low 20s because of the recent large price swings in the gold market.

However, COMEX option floor trader Jonathan Jossen cautioned that the heavy bets in out-of-the-money calls could just be part of a complex strategy by investors to hedge their downside risk by using covered call writing, which combines a short call and a long future.

"The option market is so black-boxed that you don't even know why they are doing things," Jossen said.

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