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Using a strip strategy in a volatile gold market

Cedric Okou
January 17, 2017
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Using a strip strategy in a volatile gold market

There have been some major shifts in the bond markets over the last few months. Bond rates have jumped and the uncertainties have grown. At the same time, the gold market remains highly influenced by what happens in the bond markets. Gold is usually seen as a safe haven that can provide a natural hedge against bond risk. For investors, higher interest rates represent a greater opportunity cost on their gold holdings, and this may explain the recent bearish trend in the precious metal indices. For example, the exchange-traded fund (ETF) iShares S&P/TSX Global Gold Index ETF (TSX: XGD) plunged 23.79% from November 1, 2016 to December 16, 2016.

Will this bearish trend continue? Overall, the opinions seem rather mixed:

  1. Some analysts believe that bond rates will climb inexorably in the wake of historically low levels and revive growth. If this is true, then we can expect XGD to continue to fall, or at least stabilize.
  2. Others believe that the economic environment is still fragile. Among their reasons, they point out that the Bank of Canada intends to maintain its key interest rate at 0.5%.

Based on the current evidence and both of the above arguments, one might expect large fluctuations in the price of XGD, with a drop more likely than an increase.

How can an option strategy be used to make the most of this situation?

An investor could go long in a strip strategy, buying a call option and two put options on XGD. All of the options will be at-the-money (or close to it) and have the same expiration.

The following table summarizes market information on December 16, 2016 as well as the revenues from call and put option strategies at a same strike of $11 and expiring on January 20, 2017 under three different scenarios (S1, S2, S3).

Strategy Price or Cost ($) Net Profit or Loss* if XGD goes to: Return if XGD goes to:
    S1: $9 S2: $11 S3: $13 S1: $9 S2: $11 S3: $13
XGD $10.98 -$1.98 $0.02 $2.02 -18.03% 0.18% 18.40%
Call on XGD $0.53 -$0.53 -$0.53 $1.47 -100% -100% 277.36%
Put on XGD $0.57 $1.43 -$0.57 -$0.57 250.88% -100% -100%
Strip = 1 call + 2 puts $1.67 $2.33 -$1.67 $0.33 139.52% -100% 19.76%

* Ignoring the impact of capitalizing the option premiums on the start date.

It is worth noting that:

  • Using an option strategy usually costs less than holding the underlying stock.
  • If XGD falls to $9 (S1), the put option will generate a large return of 250.88%. The call option is not exercised, and the loss is limited to the premium: $0.53. Our strip strategy generates a high return of 139.52%.
  • If XGD is flat at $11 (S2), all the option strategies generate losses equal to their cost.
  • If XGD increases to $13 (S3), the call option generates a large return of 277.36%. The put option is not exercised and generates a loss of $0.57. The return on the strip strategy (19.76%) surpasses the return on holding units of XGD.

Ultimately, the strip strategy generates income when XGD rises above the strike or falls below it, but the profit is much greater below the strike.

Cedric Okou
Cedric Okou https://sites.google.com/site/cedriciltisokou/

Cédric Okou is an associate professor in the department of finance at the University of Quebec in Montreal, after holding various analyst positions in the industry. His agenda focuses on the robust assessment and management of various types of risk, the analysis of corresponding premia, and their implications in terms of multi class asset allocations. He is particularly interested in the information content of derivative instruments, namely options.

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