An option is a type of investment where the value is dependant upon the underlying value of some other investment. In most cases, the underlying investment is stock but this does not have to be the case as it could also be a commodity, index, or real estate among other things. The option itself is a contract between a buyer and seller where each side attempts to anticipate price fluctuations.
Options have four basic components: 1) The underlying stock, commodity, etc., 2) The expiration date – options are time-sensitive and part of the risk is that the price may not rise or fall as anticipated by the expiration date, 3) The strike price – this is not the current price but what the price is expected to be by the expiration date, and 4) The premium – this is the price the investor pays for buying the option and is separate from the underlying value of the stock, commodity, etc.
Precious metal options are contracts where investors try to anticipate price movements in a specific metal. For investors, there are some major advantages and disadvantages to investing in precious metals. Gold, for instance, is seen as a hedge against rapid inflation or a fall in stock prices.
Historically, gold does not drop in value at the same rate as currency. Another benefit of precious metal investments is that they can be easily liquidated.
Unfortunately, precious metal options are also very risky investments.
In fact, they are riskier than most investment opportunities and the reason for this is simple: prices can fluctuate wildly. Precious metals are considered highly volatile. In fact, the chances of a loss are great, and using leverage actually increases the odds of a major loss. It is not only possible to lose your entire investments, but also for those losses to exceed your investment. The use of leverage (i.e. debt) can actually cause losses to mount faster than if there was no debt involved. This is why anyone considering options involving commodities like precious metals should never risk more than they can afford to lose – in other words, avoid investing by using margin at all costs.
Novice investors should stay away from precious metal options at all costs. There are a number of unethical financial advisers who will promise huge returns in record times. Some common warning signs that are typical among unethical financial advisers with respect to precious metals are:
However, while there are increased risks with precious metal options, there is also an enhanced chance for profit. This is especially true right now because of the several factors that are currently affecting the precious metals markets. One such factor is that many mines have shut down or been consolidated in recent years (true for both gold and silver). Thus, for the first time in recent memory, supplies are truly running low in many established mines. Now there are surely other mines to be discovered, but it costs money to investigate and find new ones so the present supply shortage will not disappear any time soon. This is especially true since the profits at most established mines are down and thus money for exploration is simply not there.
In the past, supply shortages (especially in gold and silver) were handled by the Central Banks releasing reserves onto the open market. However, this practice of selling reserves has all but been reversed in recent years. In fact, many Central Banks are actually increasing their reserves and further constraining supply. This brings up the other reason why precious metal options are looking really great for investors right now: increased demand.
Recently, as far as gold is concerned the creation of Exchange Traded Funds or ETF’s has seen them buy up large amounts of gold and remove it from the open market. This has spurred investors to buy up even more gold and further constrain supply. There was also the recent creation of the Shanghai Gold Exchange which is pulling gold off the market as well. In addition, the recent economic boom in both India and China has created large middle classes in both countries – middle classes that are hungry for gold and silver, trends that add even more demand pressures to an already contracting marketplace. It is no accident that gold made major gains in 2005 and there is nothing to indicate that the trend will not continue as reduced supply and increased demand will continue to drive prices upwards.
Another reason to consider call options involving gold is that conditions today are similar to those in 1980. What happened in 1980? The highest price for gold futures was posted that year at $873 (today (i.e. in 2006), the current price hovers around $650/troy ounce). Factors driving up the price of gold that year were inflation and political unrest.
Inflation in 1980 accounted for a 13 percent increase in consumer prices. In large part, the inflation was driven by record prices for crude oil – sounds familiar? In addition, political unrest in the Middle East (at that time, Iran was holding American hostages and was no longer exporting to the West – helping to fuel price increases in crude oil) also created inflationary pressures as well. Today, we have a slowing economy, record-level fuel prices, and more instability in the Middle East than at any other point in recent history.
Although the dollar made significant gains against the Euro last year, the fact remains that it did not appreciate anywhere near the rate of gold. In fact, gold appreciated faster than all currencies and surged 45% in value. Why? Because wise investors know that during times of inflation, the surest way to preserve purchasing power is with gold. There is a reason why Central Banks are once again building their gold reserves and why the International Monetary Fund uses gold as its standard. All markets, currencies, and exchanges were originally based upon gold and it has been used as a benchmark of value in some form or other for thousands of years. When all else fails, there will always be gold. In times of inflation and volatility, gold prices always go up….period. There will be fluctuations due to supply and demand, but the overall trend during times of inflation is increasing gold prices.
As far as silver is concerned, there have been supply problems for more than a decade. Part of the problem is that nearly all of the mines above the surface of the earth have been sapped. While experts agree that there are plenty of mines left to be discovered underground, the increased costs of both locating and exploiting such sites seem certain to drive prices upward in the years to come. Even China, which has for years been exporting significant quantities of silver, has recently cut exports. The government says that its mines are also running out meaning there may be no relief to the supply problems any time soon.
In addition to supply problems, there seems to be no lessening of demand for silver. The U.S. government continues to purchase 8 million ounces of silver each year for its American Silver Eagle program. There is also speculation that an ETF may be established for the silver market in the near future. If that happens, experts speculate that up to 100 million ounces of silver will be purchased and removed from the market – sending prices spiraling upwards.
So, at least as far as silver and gold are concerned, precious metals investments look sound for years
to come. Unless dramatic relief appears on either the supply or demand side, prices are bound to go higher. However, the problem for an investor looking at precious metal options is time and trying to guess how much the price will fluctuate in a given period.
Where any type of option is concerned, pricing is based upon the difference between the strike price and the current price with the expiration date factored in. The longer the option has to go before expiration, the higher the premium will be. Premiums will be lower for options whose strike price is farther away from (more “out-of-the-money”) the market price. While investors may be tempted by the potential for huge profits (and low premiums) of gold options that are more “out-of-the-money”, the volatility of the precious metals market makes these very, very risky investments. Beginning investors who are considering investing in precious metal commodities should stick with options that have a strike price that is closer to market price as the risks are much lower – especially in these times of decreased supply and increasing demand.