by Mike Sabo

Gold saw a resurgence on Tuesday, February 16 after a period of consolidation, as April gold futures posted their biggest one-day gain in three months, closing above $1,119 an ounce. If you are bullish gold but a little leery of buying futures given the volatility in this market, an options ratio spread might be a strategy to consider.

Gold had a great run in late 2009, reaching a record high above $1,200 in December, but soon fell back. We saw a downward channel formation on the chart, but finally, on February 16, gold surged more than $29 and broke out above the upper trendline of the bear channel, as you can see on the chart. I think the trend may be turning for gold, and the technical picture is now looking bullish.

On the fundamental side, money is still being printed not just here in the U.S., but around the world, a potentially inflationary scenario in the long-term. And, resolution to the debt crisis in Greece in the short-term should trigger a dollar pullback, which would benefit gold.

If you are bullish but want defined risk, you could buy one April 1125 gold call, which is trading at about $28.50 and expires on March 25. That call is very close to the market and will cost you about $2,850, plus your commission costs. If gold sells off and is trading below $1,125 at expiration, you’d lose $2,850 if you had just bought that call. Gold would need to be trading above $1,153.50 at expiration for you to break even. Since this is a rather expensive trade with a high breakeven threshold, you might consider a one-by-three ratio spread.

To do a ratio spread, you could buy the April 1125 call, but then sell three April 1200 calls. You would collect premium on the calls sold to help finance the 1125 call purchased. If you paid $28.50 for the call and sold three calls against it at about $8.50 each (bringing in $25.50) your net cost is $3 for this trade. You lower your cost basis, but you take on a different risk profile than just buying the one call. Let’s talk about what this means. One of your calls is covered by your long 1125 call, but you are naked two 1200 calls. You can get out of those options at any time, but your risk is potentially unlimited.

The goal is for gold to move slightly higher, trading up to $1,200 by March 25 at option expiration. If gold is trading at $1,150, you wind up making a gross profit of $2,500, not including your commission costs. You can take advantage of an upside move with this strategy, but you don’t really want gold to move above $1,200. Your breakeven point is $1,236. So, you would need to see gold make new contract highs to lose money on this trade. If gold moved to say $1,210 at expiration, you would make $75 on the way up, and then give back $10 on two of your 1200 calls or $20 total, for a gross profit of $5,500, not including commissions.

Say we are dead wrong, suppose the dollar strengthens and gold sells off to $1,000 an ounce by expiration. If you left the trade on as is, you’d lose the $300 ($3 net cost per 1×3) that you paid for the trade, plus commissions. Your maximum profit potential would be $7,200, minus your trade costs.

Please feel free to call me to discuss this strategy in further detail, or with other questions you might have about the markets.

Mike Sabo is a Senior Market Strategist with Lind-Waldock. He can be reached at 800-798-7671 or via email at msabo@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

© 2010 MF Global Holdings Ltd. All Rights Reserved.