The advent of the exchange-traded fund (ETF) has ushered in a new era for investors. In the old days, if an investor wanted a portfolio of small cap stocks or large cap stocks or growth or value plays, the only choice was to identify a basket of stocks that appeared to fit the desired criteria and to buy as many of those stocks as one's capital would allow. Likewise, individuals who wanted to trade currencies and physical commodities had little choice but to venture into the realm of futures trading. Today, via the purchase of the proper ETF, an investor can gain exposure to investments in a wide variety of investment vehicles and "styles". In fact, a vast array of commodity products can now be traded as easily as one would buy or sell an individual stock.

TUTORIAL: Exchange-Traded Fund (ETF) Investing

Two of the most heavily traded metals market ETFs are SPDR Gold Trust and iShares Silver Trust (in this article, we will be using their prices from 2008-2009 as examples.) Both of these ETFs are designed to track the price of the underlying precious metal in their names. GLD tracks the price of gold bullion (divided by a factor of 10). SLV tracks the actual price per ounce of silver bullion. In other words, if gold bullion is trading at a spot price of $800 an ounce then we can expect GLD to be trading at approximately $80 a share, like it did in 2008-2009.

Likewise, if silver bullion is trading at $12 an ounce, we can expect SLV to be trading at approximately $12 a share. So a bullish investor who wanted to hold a long position in gold could buy 100 shares of GLD for $8,000 (100 x $80). A bullish investor who wanted to hold a long position in silver could buy 100 shares of SLV for $1,200 (100 x $12). For most investors this is a much simpler process than buying the physical metal (which involves additional storage and insurance costs) or buying futures contracts. (To learn more, see The Gold Showdown: ETFs Versus Futures.)

A Quick Primer on Options on ETFs
Many popular ETFs - including GLD and SLV - now have call and put options available for trading. A call option gives the buyer the right but not the obligation to buy 100 shares of the underlying security up until the time the option expires. A put option gives the buyer of the option the right but not the obligation to sell 100 shares of the underlying security up until the time the option expires. A call option will typically rise in price as the price of the underlying security rises; a put option will typically rise in price as the price of the underlying security declines.

Option trading strategies open up a wide array of possibilities for traders. The primary advantages to trading options is that doing so can allow a trader to enter into a bullish, bearish or neutral position (i.e., positions that make money when the underlying security remains in a particular price range) depending on a given trader's market outlook. Option trading also offers traders the potential opportunity to speculate on price direction at a fraction of the cost of buying the underlying security itself. (For a background on options, see our Options Basics Tutorials.)

The primary risk associated with buying call or put options is that they have a limited life and an expiration date, after which they cease to exist. If the underlying security fails to move in the anticipated direction prior to option expiration, it is possible that an option that you purchased may expire worthless or the strategy that you are using may run out of time to reach its objective.

Playing a Rise in the Price of Gold Using Call Options
Let's look at a bullish option trade using options on the ETF ticker symbol GLD. As you can see in Figure 1, on the date indicated by the upward pointing arrow, the 10-day moving average for GLD crossed back above its 30-day moving average. In addition, GLD had just recently moved above its 200-day moving average. A simple analysis might conclude that gold was re-establishing a bullish trend and that the price of gold may soon move higher.

Figure 1: GLD moves to the upside
Source: Optionetics ProfitSource

The most direct play with which to take advantage of a decline in the price of SLV would be simply to sell short 100 shares of SLV at $12.77 a share. This would however, involve putting up and maintaining the required amount of margin money and would also expose a trader to unlimited risk on the upside if silver suddenly rocketed higher. A less expensive and far less risky alternative would be to buy an at-the-money put option. Figure 5 shows that at the time of the SLV price breakdown, the July 13 put option was trading at $1.75 per contract. Because each contract is worth 100 shares of the underlying security, a trader would pay a "premium" of $175 to buy one July 13 put option.

At the time of purchase, this option has 130 days left until expiration so by spending $175 to purchase this option, the buyer has the right to sell 100 shares of SLV at a price of $13 a share at anytime during the next 130 days, regardless of how far SLV may fall. Figure 6 displays the risk curves for this trade.

Figure 2: Buying a GLD call option
Source: Optionetics ProfitSource
Figure 3: Risk Curves for GLD call option
Source: Optionetics ProfitSource

The breakeven price for this trade is equal to the strike price plus the premium paid. So for this trade, the breakeven price is equal to $93.10 (strike price of $88 plus $5.10 premium). In other words, if this trade is held until expiration and GLD is below $93.10 then this trade will lose money. If GLD is above $93.10 then this trade will make money. But remember, the trade does not have to be held until expiration. A trader could simply to sell the option if it rises in price rather than exercising it and buying the underlying shares.

Playing a Decline in the Price of Silver Using Put Options
Now let's look at a bearish option trade using options on the ETF ticker symbol SLV, which tracks the price of silver bullion. As you can see in Figure 4, on the date indicated by the downward pointing arrow the 10-day moving average for SLV crossed back below its 30-day moving average. In addition, SLV also moved back below its 200-day moving average. A simple analysis might conclude that silver was re-establishing a bearish trend and that the price of silver may soon move lower.

Figure 4: SLV possibly beginning a downtrend
Source: Optionetics ProfitSource

The most direct play with which to take advantage of a decline in the price of SLV would be simply to sell short 100 shares of SLV at $12.77 a share. This would however, involve putting up and maintaining the required amount of margin money and would also expose a trader to unlimited risk on the upside if silver suddenly rocketed higher. A less expensive and far less risky alternative would be to buy an at-the-money put option. Figure 5 shows that, at the time of the SLV price breakdown, the July 13 put option was trading at $1.75 per contract. Since each contract is worth 100 shares of the underlying security, a trader would pay a premium of $175 to buy one July 13 put option. This premium represents the maximum amount that the option trader would risk on the trade.

At the time of purchase this option has 130 days left until expiration. So in sum, by spending $175 to purchase this option, the buyer has the right to sell 100 shares of SLV at a price of $13 a share at anytime during the next 130 days, regardless of how far SLV may fall in the meantime. Figure 6 displays the risk curves for this trade.

Figure 5: Buying an SLV put option
Source: Optionetics ProfitSource
Figure 6: Risk Curves for SLV put option
Source: Optionetics ProfitSource

The breakeven price for a long put trade is equal to the strike price minus the premium paid (in this instance $11.25 or a strike price of $13 minus $1.75 premium). If this trade is held until expiration and SLV is above $11.25, then this trade will lose money. If it falls below $11.25 then this trade will make money. (For a look at short selling, see Finding Short Candidates With Technical Analysis.)

The Bottom Line
Precious metals have long held something of a mystique for many investors. However, they have also long been out of reach to the majority of investors. Precious metals based ETFs have opened up a way for traders and investors to access these markets and options on these ETFs allow traders to take advantage of a variety of low-risk, high potential methods that simply were not available to them previously. In both of the examples shown here, a trader was able to play the metals markets in a particular direction without having to buy or sell short either the physical bullion or a futures contract. In each case the trader enjoyed not only a limited dollar risk but a smaller outlay and a lower dollar risk than he would have been exposed to had he simply bought or sold short the underlying shares. These trades only scratch the surface of the potential opportunities available using options on gold and silver ETFs. (For an in-depth look at ETFs, check out our Investopedia Special Feature – Exchange Traded Funds.)

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