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In my recent question, I asked how to operate with options. Now I would like to see whether I learned anything.

At this moment, Gold is rising. Fast. As I see it, in the future, the gold price has to come down (just like houses peaked and then dropped). If I want to bet against gold, I should buy a 'Put option' for example at the current price in six months. If the price goes up, I lose my bet. If the price goes down, I can 'sell' gold at todays price. Right?

The question is: how do I protect my investment so that if the price goes up I don't lose my money?

Edit: I've started a bounty. The answer should be about how to protect the 'bet' in such a way that the possible losses are known beforehand.

Edit: I'm really interested in knowing whether it is possible to eat your cake and have it too. Can you bet against the stock (or gold) but still win if it rises. I guess there is some case where you'll lose, but it should be possible to calculate how much beforehand.

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If you're placing a "bet", you don't have an "investment" to protect... –  bstpierre Sep 22 '10 at 22:55
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but if its a spreadbet you would need a stop loss –  NimChimpsky Sep 23 '10 at 11:10
    
How much money do you have that you can throw away without losing sleep? If the answer is less than $25k, you have no business playing with options. –  duffbeer703 Sep 23 '10 at 21:22
    
Actually, as options are too complicated for me, I put this question as a mental exercise. I don't have 25K€ to spare. What is a spreadbet? –  GUI Junkie Sep 23 '10 at 22:04
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A spreadbet is fodder for another question... :) –  bstpierre Sep 25 '10 at 0:38

4 Answers 4

up vote 17 down vote accepted
+50

Your plan already answers your own question in the best possible way:

If you want to be able to make the most possible profit from a large downward move in a stock (in this case, a stock that tracks gold), with a limited, defined risk if there is an upward move, the optimal strategy is to buy a put option.

There are a few Exchange Traded Funds (ETFs) that track the price of gold. think of them as stocks that behave like gold, essentially. Two good examples that have options are GLD and IAU. (When you talk about gold, you'll hear a lot about futures. Forget them, for now. They do the same essential thing for your purposes, but introduce more complexity than you need.)

The way to profit from a downward move without protection against an upward move is by shorting the stock. Shorting stock is like the opposite of buying it. You make the amount of money the stock goes down by, or lose the amount it goes up by. But, since stocks can go up by an infinite amount, your possible loss is unlimited.

If you want to profit on a large downward move without an unlimited loss if you're wrong and it goes up, you need something that makes money as the stock drops, but can only lose so much if it goes up. (If you want to be guaranteed to lose nothing, your best investment option is buying US Treasuries, and you're technically still exposed to the risk that US defaults on its debt, although if you're a US resident, you'll likely have bigger problems than your portfolio in that situation.)

Buying a put option has the exact asymmetrical exposure you want. You pay a limited premium to buy it, and at expiration you essentially make the full amount that the stock has declined below the strike price, less what you paid for the option. That last part is important - because you pay a premium for the option, if it's down just a little, you might still lose some or all of what you paid for it, which is what you give up in exchange for it limiting your maximum loss.

But wait, you might say. When I buy an option, I can lose all of my money, cant I? Yes, you can.

Here's the key to understanding the way options limit risk as compared to the corresponding way to get "normal" exposure through getting long, or in your case, short, the stock:

  • If you use the number of options that represent the number of shares you would have bought, you will have much, much less total money at risk.

  • If you spend the same "bag 'o cash" on options as you would have spent on stock, you will have exposure to way more shares, and have the same amount of money at risk as if you bought the stock, but will be much more likely to lose it.

The first way limits the total money at risk for a similar level of exposure; the second way gets you exposure to a much larger amount of the stock for the same money, increasing your risk.

So the best answer to your described need is already in the question: Buy a put. I'd probably look at GLD to buy it on, simply because it's generally a little more liquid than IAU.

And if you're new to options, consider the following:

  • "Paper trade" first. Either just keep track of fake buys and sells on a spreadsheet, or use one of the many online services where you can track investments - they don't know or care if they're real or not.

  • Check out www.888options.com. They are an excellent learning resource that isn't trying to sell you anything - their only reason to exist is to promote options education.

If you do put on a trade, don't forget that the most frustrating pitfall with buying options is this: You can be basically right, and still lose some or all of what you invest. This happens two ways, so think about them both before you trade:

  • If the stock goes in the direction you think, but not enough to make back your premium, you can still lose. So you need to make sure you know how far down the stock has to be to make back your premium. At expiration, it's simple: You need it to be below the strike price by more than what you paid for the option.

  • With options, timing is everything. If the stock goes down a ton, or even to zero - free gold! - but only after your option expires, you were essentially right, but lose all your money. So, while you don't want to buy an option that's longer than you need, since the premium is higher, if you're not sure if an expiration is long enough out, it isn't - you need the next one.

EDIT to address update: (I'm not sure "not long enough" was the problem here, but...)

  • If the question is just how to ensure there is a limited, defined amount you can lose (even if you want the possible loss to be much less than you can potentially make, the put strategy described already does that - if the stock you use is at $100, and you buy a put with a 100 strike for $5, you can make up to $95. (This occurs if the stock goes to zero, meaning you could buy it for nothing, and sell it for $100, netting $95 after the $5 you paid). But you can only lose $5. So the put strategy covers you.

  • If the goal is to have no real risk of loss, there's no way to have any real gain above what's sometimes called the "risk-free-rate". For simplicity's sake, think of that as what you'd get from US treasuries, as mentioned above.

  • If the goal is to make money whether the stock (or gold) goes either up or down, that's possible, but note that you still have (a fairly high) risk of loss, which occurs if it fails to move either up or down by enough. That strategy, in its most common form, is called a straddle, which basically means you buy a call and a put with the same strike price. Using the same $100 example, you could buy the 100-strike calls for $5, and the 100-strike puts for $5. Now you've spent $10 total, and you make money if the stock is up or down by more than $10 at expiration (over 110, or under 90). But if it's between 90 and 100, you lose money, as one of your options will be worthless, and the other is worth less than the $10 total you paid for them both.

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You're good. This is a very thorough explanation. Are you already supporting the Quantitative Finance stackexchange? –  Raskolnikov Nov 20 '10 at 15:19
    
@Raskolnikov, first off, thanks. And no, I haven't checked it out yet, but I will. –  Jaydles Nov 20 '10 at 16:49
    
A great comment. I've learned a lot. Please take a look at my second edit for clarification. Cheers. –  GUI Junkie Nov 20 '10 at 18:53
    
Ok, so I was looking for an explanation of 'straddle'. Thanks! –  GUI Junkie Nov 20 '10 at 20:21
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@muro, thanks for the compliment. As to the treasuries comment, you're correct that nothing is guaranteed, and you can still lose money in the event of a default, as I mention, but as to the fluctuations you reference, while you're correct that your mark to marktet can go down, barring default, you're a still guaranteed your principal at maturity. Now, you might have made less in interest than inflation, but that's a whole 'nother discussion... –  Jaydles Nov 22 '10 at 2:35

You'll still lose a little bit if you buy a put option at the current price. No such thing as free hedging.

Let's say you have 100 shares of IAU that you bought for exactly $12.50 per share. This is $1,250. Now let's say you bought a put option with a strike price of $13 that expires in April 2011. The current price for this option is $1.10 per share, or $110. You can sell your IAU for $1,300 any time before the expiration date, but this leaves $60 in time value.

The price of the options will always have a time component that is a premium on the difference between the current price and the strike price. (Oh, forgot to add in commissions to this.)

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Make a portfolio with gold and put options for gold. If the price rises again, sell a part of your gold and use it to buy new put options. If the price goes down, then use your put options to sell gold at a favorable price.

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This plan doesn't really make sensein this case, as the OP things gold is more likely to go down than up - and this strategy (gold plus puts on gold) makes money of gold goes up and loses money (albeit usually less money) if gold goes down. –  Jaydles Nov 20 '10 at 14:15
    
Yeah, I see what you mean. With my strategy, he covers his ass for devaluation of gold. But he wants to cover his ass for devaluation of his options on gold. But then, is it not possible to reverse the strategy and short sell? Or would the transaction cost of shorting be too high for that to be efficient? What about combining with call options instead? –  Raskolnikov Nov 20 '10 at 14:21
    
Actually, if he shorts call options, he should be able to cover his puts, no? –  Raskolnikov Nov 20 '10 at 14:51
    
OK, I've read your post and it addresses all the issues I have brought up here. I'm gonna upvote your post, it deserves better than 2 votes. –  Raskolnikov Nov 20 '10 at 15:13

gold is incredibly volatile, I tried spreadbetting on it. During the month of its highest gain, month beginning to month end, I was betting it would go up - and I still managed to lose money. It went down so much, that my stop loss margin would kick in.

Don't do things with gold in the short term its a very small and liquid market.

My advice with gold, actually buy some physical gold as insurance.

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I like what you have to say, except that I wouldn't buy actual metal as an investment nor as insurance. –  Alex B Sep 28 '10 at 16:39
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I like the answer, but I actually think the price of gold will go down... sometime. –  GUI Junkie Nov 8 '10 at 22:56
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I think your reference to liquidity is off. If you really mean "liquid", that's a positive. Liquid markets are more efficient, and make transactions effectively cheaper. If you meant "illiquid", I'm not sure that's accurate about gold. While it is volatile, intstruments pegged to its value (futures, ETFs, etc.) are, in aggregate, highly liquid and transparent. –  Jaydles Nov 19 '10 at 23:25

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