A Put to Protect a Long Gold Position

All examples are as of March 23, 2011.

This is the simplest example. It is a tactical defensive options play.

Suppose you are long 500 shares of the gold ETF, GLD. This is equivalent to 50 oz. of gold. You are concerned: Gold has moved up a long way and the market is heavily long. You worry that a retracement may be in the offing, and you do not want to be stopped out of you position. So you buy five GLD May 2011 puts with a strike of 130 (equivalent to a put on 500 oz.). This limits your absolute loss and enables you to ride out the reaction. The top picture at the right shows the input screen.

The second picture is a graph from OptionsPortfolio of the gain/loss of your combined stock and options position at prices of gold from of 120 to 156. Note that the shape of the upside is much like being long gold, but the downside flattens out at the limited loss of about $5,600. That's the shape you had generally hoped for. Now, you have hard numbers to plan your risk management.

To a professional options trader this is only the beginning. There are a lot of other risk questions that should be answered before you put the trade on. Foor example, what happens as time goes by. You know that if the market stagnates the options will slowly lose value, but how much? Note the red line. That tells you what the gain/loss of the portfolio will be on any date before expiration, in this case April 15. As you may guess, the red line is lower than the base case, reflecting the loss of time premium as time goes on.

Another risk is what would happen if implied volatility changes. For example, if gold undergoes a massive speculative liquidation as you conjecture, it is reasonable to think volatility will go up. The green line shows the case in which vol increases by 34%. This is to your benefit; at almost all prices, you do better than the base case. Since you are long an option, you gain with increasing vol.

Everyone who buys options worries about the time decay they will pay. The third picture is the time decay of the combined trade. This is called the theta. At the time you put the trade on, you can expect to lose about $15 per day (black line). If the market moves up the value of the option declines and you lose less in time decay and vice versa.

One thing to note on all these graphs. There are two X-axes, one in black and one in red. This is to adjust for dividends the stock pays. Since GLD does not pay a dividend, the two lines are equal.