Building on Richard’s observations on a possible short-term correction on gold, I thought it might be interesting to look at a bear put spread on XGD (iShares S&P/TSX Global Gold Index Fund).  Unlike Richard’s observation, which is fantastic for income generation, the bear put spread will capitalize on a directional move down.  As a result, you must be of the belief that a short-term continuation lower in the XGD is a high probability.

At present, the XGD is sitting at $24.44.  The objective is to purchase January 25-strike put options to capitalize on a short-term bearish outlook, and in order to offset some of the cost, sell January, 23-strike puts. Remember that the benefit of the spread is that it limits the risk exposure by lowering the cost basis of the trade, however the profit is limited to the spread minus the debit.

To simplify (based on current option pricing):

BUY 1, January expiration, 25 strike puts - $1.60 Debit
SELL 1, January expiration, 23 strike put - $0.65 Credit
Net debit = $0.95

Max Risk = $0.95
Max Profit: $2.00 spread minus $0.95 Debit = $1.05

Remember that unlike the bull put spread, time is working against you with the bear put spread. If XGD starts heading to the upside, it may be worth considering cutting your losses. If XGD is above 25 on the third Friday of January, 2011, the options will expire worthless and you will lose your entire premium.

For a technical perspective of the XGD bear put spread, click on the link below to view the chart.

XGD Daily Price Chart - Oct 26, 2010

All the best
Jason