Gold Covered Call Managed Futures Long-Term Trading Program
Structural Logic’s Gold Covered Call Writing program is a unique managed futures strategy that involves a combination of long gold futures contracts and short gold call options. This gold covered call program has one “beta” component, and two “alpha” components. Academic research has shown that the majority of managed funds (over 80%) returns are attributable to market-driven “beta” strategies, with the remaining portion of the returns being derived from “alpha” strategies.
For the “beta” component, the Advisor intends to maintain a perpetual long futures position by rolling the front month futures contract forward to the deferred month futures contracts. Maintaining a perpetual long-only gold futures position by rolling the futures contract forward to the deferred futures contracts offers investors a “beta replication” approach to owning physical gold.
Writing Call Options
The first alpha component of the gold covered call program is derived primarily from writing call options on the underlying gold futures contracts that are either “at-the-money” slightly “out-of-the-money” or slightly “in-the-money.” In this program, the perpetually long-only futures contract fully collateralizes the obligations conveyed by writing a call option contract. Income is generated by capturing a small premium from the writing covered calls, Additionally, when deemed appropriate by the Advisor, puts may be purchased from time to time for additional downside risk protection to the perpetual long-only gold futures position.
Covered call programs perform best when the asset’s market value experiences little range over the lifetime of the call contract. The income generated from the writing of the calls also provides a small measure of protection against a decline in price of the underlying asset and a small measure of profit participation should the asset with an increase in asset’s price. It generates income because the investor keeps the premium received from writing the call. On the other hand, the covered call program may limit the upside participation of the “beta replication” component of the trading program in the event that gold prices experience rapid price appreciation. The covered call is widely regarded as a conservative strategy because it decreases the risk of asset ownership.
The risk of financial loss with this strategy comes from the long gold futures position. This loss can become substantial if the gold futures price continues to decline in price as the written call expires. At the call’s expiration, loss can be calculated as the current market price of the gold futures contract less its original purchase price, plus the premium received from initial sale of the call .Any loss accrued from a decline in the gold futures price is partially offset to the extent of the premium received from the written call option.
While managing the Gold Covered Call Writing Program, the Advisor’s opinion in the underlying position may change before the call option expires. In addition, there comes a time in the options cycle that premium erosion becomes stagnant with less than two weeks remaining. When this occurs, the premium left offers little offset or protection on the down side should the futures price decline during the final two weeks of the options life cycle.
It is anticipated that in order to increase the upside potential of the program, when the underlying futures contract goes “into-the-money,” the Advisor may at its discretion “roll” the covered call up and “overwrite” the option at a higher strike price, or re-establish the strategy using a different expiration date and strike price – as a conservative path to take to continue the income stream and preserve downside protection.
Furthermore, when the downside risks to gold are perceived to be substantial, the Advisor may decide to “collar” the underlying gold futures position by purchasing a put option in order to protect the long gold position from further decline. This is known as a “married put” position.
Investors in the Gold Covered Call Writing program should also be aware that they may be assigned an exercise notice on written options if the option is in-the-money at option expiration. If the written option expires exactly at-the-money, assignment of an exercise notice is possible, but should not be assumed. It should be noted that the Advisor does not control which client accounts are assigned an exercise notice, it is possible that some accounts may receive an assignment while others do not. Under such circumstances, the Advisor will take appropriate action to realign positions in client accounts as quickly as possible.
Margin to Equity Ratio
The second alpha component is derived from maintaining an appropriate margin to equity ratio exposure on the perpetually long-only futures position. Margin to equity ratio represents the percentage of capital being held as margin. Rarely (and unadvisedly) would it be appropriate to hold 100% of their capital as margin. The probability of losing their entire capital at some point would be high. By contrast, if the margin-equity ratio is so low as to make the trader’s capital equal to the value of the futures contract itself, then they would not profit from the inherent leverage implicit in futures trading. A conservative approach might hold a margin-equity ratio of 10-15%, while a more aggressive approach might hold 30% or more.
The initial margin on a Comex gold futures contract as of August 10 2013 is $8800 and the maintenance margin is $8000 (initial and maintenance margins are subject to change in the future). The minimum initial investment amount for this covered call program is $50,000. The initial margin to equity ratio is 17.6%, and the maintenance margin to equity ratio is 16%. If the price of gold appreciates, the margin to equity ratio will decrease. If the price of gold decreases, the margin to equity ratio will increase.
Research shows that the best performing CTA’s maintain margin to equity ratios between 10% and 30%. To maintain an appropriate “beta-replication” exposure to the underlying metal, the Advisor will at his sole discretion, seek to maintain a margin to equity ratio somewhere in the 10% to 25% range.
Assuming a scenario where the underlying price of gold appreciates, the equity in the perpetually long-only futures position will increase as well. If the equity in the “beta-replication” perpetually long-only futures position increases to $100,000 and the initial and maintenance margin remain fixed, the margin to equity ratios would fall to 8% and 8.8%, respectively. To maintain an equity to margin ratio above 10%, the program will be required to add another Comex Contract at that time.
The mini-gold contracts traded on the NYSE/ICE Exchange are a more suitable product than the Comex gold futures contract for managing risk and maintaining appropriate margin to equity ratios. Mini-gold contracts are one-third the value of a full size futures contract on the COMEX Exchange. Initial Margin and Maintenance Margins on the mini-gold contracts are $4690 and $2656 as of August 10 2013. At the sole discretion of the Advisor, for example, once the equity in the program reaches $75,000, adding one mini-gold contract may be considered. The maintenance margin of the Comex plus the initial Margin of the mini-gold contract would equal $12,656. The margin to equity ratio of 1 Comex and 1 mini-gold contract with $75,000 equity equals 16.8%, back within the 15% to 20% margin to equity ratio.
The maintenance of an appropriate margin to equity ratio will enhance the overall performance covered call program when the underlying price of the gold asset is experiencing substantial price appreciation. The risk of financial loss with maintaining an appropriate margin to equity ratio stems from a substantial decline in the price of gold. Thus, the Advisor may at its sole discretion, depending on magnitude of the perceived downside risks, reduce the long-only exposure back to the initial unit size required to maintain the “beta component’s” perpetual long-only futures position. Depending on the adversity, margin to equity ratios may even fall below 10% for a brief time.
The foregoing investment principles are factors upon which the Advisor bases its trading decisions for the Gold Covered Call Writing program. Such trading strategies have been and will be enhanced or revised from time to time. The research and trading methods of the Advisor are proprietary and confidential. The description of this program is, of necessity, general and not intended to be exhaustive.
Initial Investment Size for the Gold Covered Call Writing Program: $50,000
The minimum account size for the gold covered call writing program is $50,000, provided however, that under certain circumstances the Advisor may in its sole discretion accept smaller accounts. In order to achieve the objectives of the trading program and advisory service, a continuous commitment for at least eighteen months is strongly recommended.
Background and History of Gold as a Reserve Asset
Central banks have been major holders of gold dating back to the 1880s when they began building up their gold reserves under the classical gold standard whereby the amount of money/currency in circulation was linked to the country’s gold stock. Central banks are considered the ultimate long term investors, though they will swap, lease, or sell gold under various circumstances.
Until the 1970s, central banks kept gold for the role it served as the foundation of the of the international monetary system. Gold was considered the primary “reserve asset,” whereby central banks could convert US dollar balances into gold at the official fixed price. Gold thus provided the “anchor” to which all currencies were linked. But gradually, as central banks created more money than was consistent with stable prices, the fixed official gold price became unrealistic, and in 1971, Nixon “closed the gold window.” The US dollar was allowed to “float freely” and gold prices appreciated substantially during the 1970s.
After a bout of inflation in the 1970s and a substantial gold price appreciation, gold prices began drifting lower in the 1980s and 1990s. During the 1980s some central banks began re-appraising the role of gold as a “reserve asset” in the composition of their portfolio of “reserve assets.” Reserve managers of central banks put more emphasis on current yield in their reserve portfolios, prompting central banks began to diversify away from gold (as gold provides no yield). By 1989 central banks had become net sellers of gold.
In this environment, central banks also began swapping their gold amongst each other and leasing their gold to bullion banks. The bullion banks, in turn, sold the gold that they leased from the central banks onto the market, and subsequently reinvested the proceeds into higher yielding treasury assets. This is popularly known as the “gold carry trade.”
Also during the 1980s & 1990s, gold producers began aggressively selling forward/hedging their future production. All of these considerations conspired to put substantial pressure on the price of gold until the Washington Agreement of September 1999 when a group of European central banks agreed to limit their gold sales to 400 tons a year for a five year term. This effectively put a floor under the price of gold at $252 and the majority of gold producers stopped selling forward their future production in the early 2000s to take advantage of rising gold prices.
Partially in response to the financial crisis of 2008-09 and the subsequent hyperbolic increase in money supply and excess reserves via unconventional monetary policies, central banks became net purchasers of gold again for the first time since 1989. This shift amongst the major gold market participants left only the major bullion banks still carrying a net short position, which they carried until June 2013.
In the first half of 2013, there were substantial liquidations of paper gold and gold ETF redemptions amongst western economies amidst accelerated demand for physical gold in the East. As we enter the second half of 2014, this is where the gold narrative leaves off: with central banks as net purchasers of gold (presumably dampening central bank swaps and leasing programs), major bullion banks net long gold, gold producers hedging little of their future production, and strong demand for physical gold coming out of the East amidst a hyperbolic increase in the money supply and excess reserves: a condition which may destabilize the international monetary system.