Client:
Options Trader
Challenge:
Capitalizing on range bound gold prices
Solution:
Long put butterfly
Overview
Sometimes futures prices will appear to trend in a certain direction, whether that be up or down. At other times, they move sideways without a clear direction. This is an example of a range bound market. One possible options strategy to capitalize on a range bound product is a butterfly trade.
Approach
On March 22, 2023, May Gold futures (GCK3) are trading around 1980.0, and an options trader assesses that this is near recent highs. He uses CVOL, a volatility instrument from CME Group, and finds that CVOL on gold is around 18.50, which is also near the high end of its range in terms of the level of volatility. The trader identifies that the skew ratio of 1.25 suggests there is greater trading in calls versus puts. He also assesses that this is at the higher end.
After gathering this information, the trader believes that the Gold futures market may begin to settle down and range trade in the near-term. He decides to buy a put butterfly spread using the May expiration (34 days to expiration) to express his position.
The put butterfly spread limits the risk to the premium paid but gives the buyer the opportunity to collect on falling – or converging – volatility and time decay over the life of the options.
A put butterfly is defined by three strike prices equal distance from each other, all for the same expiration date. In this example, the body of the butterfly (middle strike) is the 1980.0 puts. The wings will be below and above that strike. A butterfly is a ratio spread, so there will be one body and two wings. This is considered a long butterfly because the trader is buying the wings and shorting the body.
| +5 OGK3 1930 Puts = $14.20 | -10 OGK3 1980 Puts = $33.10 | +5 OGK3 2030 Puts = $62.70 |
| Total debit = ($14.20 + $62.70) - (2 x $33.10) = $10.70 net premium $10.70 x 100 troy oz x 5 contracts = $5,350 net debit and maximum risk |
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Gold Put Butterfly
The trade benefits from falling volatility and time decay as long as the price of May gold stays inside the wings of the fly. The position achieves its maximum result at expiration if the underlying futures price is near the body of the fly.
Results
From late March to late April, the price of Gold futures remained relatively stable and ended up range bound.
GCK3 Contract Performance
The trader covers this position on April 21:
| -5 OGK3 1930 Puts = $0.40 | +10 OGK3 1980 Puts = $5.60 | -5 OGK3 2030 Puts = $40.50 |
| ($0.40 + $40.50) - (2 x $5.60) = $29.70 net credit $29.70 net credit x 100 troy oz x 5 contracts = $14,850 |
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Since they bought the spread at $5,350 and sold it at $14,850, the trade resulted in a net profit of $9,500.
Conclusion
The trader benefited from slightly lower volatility and time decay while limiting their risk to the premium paid since the market settled into the middle of the range, or the body of the butterfly. This is just one example of how Gold options can be used as a risk management vehicle to hedge volatility risk or market conditions.
Find your solution
Let CME Group help you find a solution to your challenge.
Watch a webinar on this topic:
A Golden Opportunity: Gold Futures and Options
Find out about other ways to hedge gold in another case study:
Hedging Risk with Gold futures and options
Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion of those funds should be devoted to any one trade because traders cannot expect to profit on every trade.
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