In my column last week, I showed you some of the spectacular moves that the four most actively traded commodities (oil, natural gas, gold and silver) have made over the past couple of years.

And when you see the wide trading ranges, it also gives you an idea of just how lucrative they can be.

But you don’t need to be an expert to take advantage. You just need to know how to play them intelligently, using strategies that minimize your risk and maximize your profit potential.

Easier said than done, right? Nope. That’s what I’m here for. And today, I’m going to show you how to add commodities to your portfolio in a much easier way than through futures or futures options, and a much better way than by just buying commodity stocks outright.

Two Reasons Why You Should Use A Put Option Strategy

Perhaps the best way to play commodities is through the options market.

But if you think “commodities and options” in the same sentence sounds scary, think again! Let me explain to you how you can do so, using one of my favorite strategies when you want to take a bullish stance.

It’s called “put-option selling.”

Let’s run through the basics first…

In the options market, a buyer of put options has a bearish stance on the underlying asset (be it the overall market, or stock). Alternatively, a seller of put options is adopting a neutral or bullish stance on the underlying asset.

And the flexibility of the options market allows you to sell options as an opening transaction instead of having to buy them.

In this case, we’re the put-option sellers – a technique that has a superb double benefit.

• You receive income upfront – yours to keep, no matter what happens with the rest of the trade.
• You have a chance to buy the underlying asset at the price you want – and at a large discount to the current price.

Here’s how it works…

Create Your Own “Discount Store”

Whenever you sell an option contract (either a call or put option), the option buyer pays you for it. This money is yours to keep and it gets immediately placed into your trading account.

When you sell a put option contract in particular, not only do you get the immediate cash payment, but you are also giving yourself the chance to buy the underlying asset at the (strike) price you select.

In short, someone is paying you cash so that you can buy the asset at the price you want. How great is that?

Let’s run through a hypothetical example – using the commodities market – to show how put-option selling is as simple as it seems…

Say you’re bullish on a gold stock, but the price has run up too much for your liking. You want to wait for a pullback to the 200-day moving average area before you buy.

Now that commodities exchange traded funds are an extremely popular and easy way to trade commodities, you decide that you’re going to use the SPDR Gold Shares ETF (NYSE: GLD). Here’s how…

How to Buy Gold At the Price You Want

GLD tracks the price movement of physical gold and is roughly one-tenth the size of the front-month gold futures contract.

And because it’s an ETF, it trades just like a stock, so you can buy and sell it through a regular stock brokerage account.

However, with it currently trading around $97, you want to wait for a pullback to the $91 area before buying, as that’s the price at which you feel comfortable owning the shares.

So what’s the best way to take advantage? Regular investors may put in a stock buy order at $91 and hope GLD comes down to that level. But if it doesn’t, you’ve wasted your time.

Here’s where the put-selling strategy comes into play.

• Instead of placing a buy order, you could opt to sell a GLD December 2009 $91 strike put option contract (GLD-XM) for $1.40 per contract.
• What does this do for us? Well, for every put option contract you sell, the option buyer will immediately pay you $140 (because there are 100 shares in each options contract – $1.40 multiplied by 100 = $140).
• If you sell 10 of these put option contracts, you’ll receive $1,400 into your trading account.

That’s right… instant cash just for placing a trade. So what’s the catch? Only that you’re obligating yourself to buy those GLD shares at $91 – which is the price you want!

However, you must ensure that you only sell as many contracts as corresponds to the number of shares you want to buy. For example, if you sell just one contract, you’re obligated to buy 100 shares of GLD for $91 by options expiration. And if you sell 10 contracts, you’d be on the hook for 1,000 shares at that $91 price.

Get Proactive Through Put Option Selling & Get Cash

So instead of just sitting and waiting to see if GLD gets back down to $91 before you buy it, at least when you sell put option contracts, you pocket $1,400 in cash (on 10 contracts) while you wait.

It’s a win-win situation: not only do you get paid money while you wait, you still gain the opportunity to buy GLD shares at the price you want ($91) if it trades back down there by options expiration.

Speaking of options expiration, let’s cover that scenario…

Your Two Scenarios At Options Expiration

Only two scenarios will occur when the December options expiration rolls around…

• If GLD is still trading above your strike price of $91, then the put options will expire worthless and you just keep the $1400 free and clear. The trade is now over.
• If GLD is trading below your strike price of $91, then you’ll be “assigned” the shares on your put options and will become a regular shareholder of GLD at $91 per share. At this point, you’ll have to pay cash in full for the shares. But remember, you get to buy GLD at your chosen price.

A few points to remember:

• You’re selling the put option contract as the opening transaction, not buying it.
• You can buy the option back any time you wish. You don’t need to wait for option expiration to take action.
• You must be approved to trade option contracts through your stockbroker. The broker will also require you to keep a portion of the money it would cost for the shares in your account during the trade (a “margin requirement”) – but not the full amount.
• If you’re assigned the shares, you simply take the same risk management actions you would for any other bullish stock position you own.

The Bottom Line on Selling Puts

If you’re bullish on a stock, but find the price is too high, why just hang around and wait for it to decline? You can earn some cash while you wait through the put-selling strategy.

If the stock ends up below your strike price (the price you want to buy the shares) at option expiration, then you succeeded in your quest. You’ll be able to buy the shares at your comfort level, while still retaining the cash paid to you on day one of the transaction. A no-brainer in my book.

Good investing,

Lee Lowell

Source: How to Buy Gold… At the Price You Want & Get Paid for It

And it’s this time component that is a critical factor when it comes to valuing the price of a LEAP option and the amount of risk involved.

An option’s price is determined by a computer program – either the Options Pricing Model or the Black-Scholes Model. Black, Scholes and Merton developed the latter model in the 1970s, winning a Nobel Prize for it.

Essentially, both models take the same main factors into account…

• The amount of time until expiration.
• The price of the underlying shares.
• The volatility of the share price.
• The risk-free rate of return.

Let’s take a look at these factors, so you know how to pick the right options with the best chance of yielding handsome profits…

Put Time on Your Side With LEAP Options

Time Until Expiration: When most people think about options, they think about getting the biggest bang for their buck and profiting in the shortest amount of time.

But be careful, because it isn’t that simple. With short-term options, time is against you. If the outcome you desire isn’t achieved within a short period of time, your option expires worthless.

However, LEAP options give you plenty of time for you to be correct and profit from the trade. Time is a critical component of a LEAPS trade.

• For example, I’ve seen a LEAP option on a gold stock recommendation move from the $3 price we paid, to $0.50, then right back up to $16… all during a 12-month period.
• Contrast that with a short-term option, which would have flamed out a long time before the share price recovered.

With LEAPS, you have time to withstand a bad earnings report, a market correction, a terrorist attack, or a plethora of other shocks that would otherwise mean a world of hurt for your position.

Stock-Watching: How the Share Price Affects the Option Price

Price of the Underlying Shares: It stands to reason that the price of the underlying shares is another key factor in determining how much you pay for the LEAPS options.

Basically, the closer the strike price (the price at which you have the right to buy or sell the stock) is to the current share price, the more expensive the option will be.

• For example, if IBM (NYSE: IBM) trades for $100, a $95 call option would be considered in-the-money since the strike price is less than the current option price. In this case, the option premium will have intrinsic value. For example, if the option cost $9, $5 of that would be intrinsic value and $4 would be the amount paid for time and risk.
• If your option is out-of-the-money, you pay for time and risk. So if IBM was at $100 and you bought a $105 call option for $5, the entire $5 would be for time and risk. But while the option premium is less than an in-the-money option, the probability of winning is also lower.

How Much Will Your Option Move? This Volatility Number Will Tell You

Volatility: When we talk about volatility here, we’re referring to how the share price performs in relation to the broader market. This is known as a stock’s beta.

Simply put, a stock with a beta of 1 will move in line with the market. A number under 1 means it’s less volatile, while a number higher than 1 means it’s more prone to volatility. So if the S&P 500 moves down 1% and your stock moves down 2%, your stock has a very high beta – double that of the market.

The higher the beta, the more expensive the options are, since options have the ability to move with greater speed in either direction.

• For example, the beta on shares of tech giant Apple (Nasdaq: AAPL) will be much higher than the beta on a stodgy pharma company like Procter & Gamble (NYSE: PG).

Risk Free Rate of Return: Measuring the cost of money at the cheapest possible price and the best possible return with no risk, this final factor is usually associated with government Treasury securities, especially 10-year Treasury bonds.

Together, these four features – time to expiration, underlying share price, volatility and risk-free rate of return – represent the critical components in determining the price of LEAP options (or any options, for that matter).

Next time, we’ll explore the economics of the LEAP strategy along with how you can invest in the market with 15% of your cash while the rest of the world is foolishly using 100% of theirs.

Good investing,

Karim Rahemtulla

Source: Put Time on Your Side With This Trading Strategy