Options

Options

Options have become the third dimension of the gold market, after physical gold and futures. This sector expanded particularly fast during the 1980s. Options are surrounded by specialised terminology and involve trading and hedging strategies of some complexity; at the outset an understanding of the language is necessary.

An option gives the holder the right, but not the obligation, to buy or sell gold at a pre-determined price by an agreed date, for which privilege he/she pays a premium. This premium, or cost of the option, is the compensation the writer or grantor receives from the buyer. The right to buy is known as a call option (‘call’) and the right to sell, a put option (‘put’). The predetermined price is known as the strike price or exercise price.

The premium is calculated based on a combination of the current gold price, the strike price, current interest rates, time to expiry and the anticipated volatility of the gold price, and is worked out using a mathematical formula called the Black-Scholes model, or a derivative of it. In fact, of the parameters mentioned above, only the anticipated volatility of the price is not known, so that most option market makers quote premiums based on similar calculations; only their expectations of volatility and therefore the position in their book will vary.

Premiums naturally fluctuate considerably, but as a general rule they are usually in the range of $15 to $25 an ounce (although on occasion they will be much higher). That is both the attraction and subsequent importance of options: they offer immense leverage because the buyer only has to pay the premium and thus can build up large positions with relatively small capital outlay.

The premium is also the only thing that is at risk for the buyer of an option, whether call or put; if the buyer paid a premium of $20 for an option, that is all he/she stands to lose. For the grantor on the other side of the options transaction, the attraction is the premium income but he/she stands exposed if the price moves against him/her and must normally hedge this exposure.

All options strategies, no matter how complicated, are made up of a combination of the two basic transactions – calls and puts. For example, say gold is $275 and a call option is bought at $300 strike price. If the price now rises to $300 during the life of the option, it is described as ‘at market’ and the holder could either exercise the option to buy gold at that price, or hold on to it. If gold then goes to $310 the call option would be 'in-the-money’ and it could be exercised to buy gold at the strike price of $300, resulting in an immediate profit.

Similarly, a put option may be purchased when gold is $300 at a strike price of $275. If gold falls below $275 before the expiry date, the holder can exercise the right to sell at $275. Mining companies in particular can buy this kind of price protection. Of course, with either the call or the put, if the strike price is not reached, the option expires worthless or ‘out-of-the-money’ with only the premium lost. The mining company, to continue that example, will not mind if a $275 put expires unexercised, with gold actually up at $350; the put provided insurance but the company could still participate in the higher price.

That is the simplest case. Complex option strategies have been devised according to the needs of the buyer, the protection or generation of income desired and expectations of what the market will do.

Normally a grantor of options would seek insurance using what is known as delta hedging, a formula measuring the amount of gold to be bought or sold to cover the exposure; the formula is a by-product of the Black-Scholes model used in initial option pricing. The variable factor in delta hedging is the measure of probability of an option being exercised against a grantor. If, for example, the strike price is $300, the closer gold gets to that price the more the grantor must buy or sell to become ‘delta neutral’. Delta hedging can have considerable impact on the market price if large options positions of 100,000 ounces or more have to be covered by the equivalent purchase or sale of part or all of this gold.