Trade in Groups

This series on commodities has taken a detour or two, but the recent explanation of how to use a covered call strategy brings us back to one of the original points about commodities: when used in combination with other strategies, they can both provide income and change the correlation of a portfolio.

A problem traditionally associated with owning physical commodities is that they require funding costs (to store and insure) and throw off no cash flow until they are sold. As was discussed with covered calls, however, selling an out-of-the-money call can provide a steady income and boost to returns, while only giving away some upside in the case of a large rally.

Two of the most popular ETFs for directly owning commodities are United States Oil (ticker: USO), which tracks the spot price of WTI crude, and SPDR Gold Shares (ticker: GLD), which tracks the price of gold bullion. Below are the charts of USO and GLD, respectively, relative to the S&P 500 over the past year.

For this trade set-up, we will focus on a covered call on gold, using the Gold ETF (GLD). Many investors have become interested in gold lately because of fears about the value of the U.S. Dollar, and gold is seen as a natural hedge against fiat paper money.

From TradeKing’s Option Summary, the historical volatility of gold over the past 30 days is 29%. But looking at the February call option chain, with expiration 22 days away, the implied volatility (IV) of the $96 strike is 39.2%. Interesting enough, the volatility of the March $96 strike call is 39.5% - this is unusual because implied volatility typically increases over time.

As a comparison, the at-the-money call for February (the $88 strike) shows implied volatility of 34.6%, while the March $88 strike call shows implied volatility of 36.5%. Two main takeaways here: the market expects volatility going forward to exceed volatility in the recent past, and it seems that out-of-the-money options sellers are being well-compensated for giving away upside above 10% between now and mid-February.

So let’s say you go ahead and own 100 shares of GLD, and you decide to sell the February $96 strike call against the long position. This results in a credit of about $80 (given what the contract’s last bid/ask is at), with that premium being equal to 0.91% of the ETF position’s cost. That might seem like a small amount, but it is for an extremely short time period – annualizing that out gives an annual return of 14.6% in premium income, all for selling a call that is 10% out of the money with 22 days to expiration. Not a bad risk/reward trade-off for someone already long GLD, in this author’s opinion, and a fairly easy way to convert direct commodity holdings to an investment that throws off cash flow while hedging against inflation.