>Gold rally may be snagged by fund option selling

London - The rally in gold may be reined in by options selling sometime in the next four to six months, if hedge funds and other institutional investors begin to view the rally as overstretched, some market observers said this week.

Options in Comex gold and the over-the-counter market are predicting the precious metal has a 25% chance of being above $1,400 per troy ounce by the end of 2010, even though few market participants will make such bullish predictions, said JP Morgan managing director Neil Clift.

At this week's annual London Bullion Market Association conference in Edinburgh, a poll of audience members found the average forecast for gold's price in September 2010 was $1,181 an ounce. On Friday at 1626 GMT, spot gold was trading at $1,092 an ounce, up 24% this year but 28% below the $1,400 an ounce level.

The disparity between the high prices predicted by options and much lower consensus price forecasts could be an opportunity for investors to sell gold options, which could trigger a significant correction in gold prices within the next six months, Clift said.

"I'm in the bullish camp. At the moment the market is in bullish mode and I actually am probably more a bull than most," Clift said. "[But] at some point we'll see people coming in to sell options. There is potential value to be had in selling away the topside. It may be a long time before that happens. But at some point it will."

Gold rallied to a record high this week on news that the Reserve Bank of India bought 200 metric tons from the International Monetary Fund. The purchase appeared to confirm predictions that central banks were losing confidence in the dollar and wanted to increase and maintain their gold holdings.

Gold's dramatic ascent since July, without any significant correction, may tempt some longs worried about a short-term correction to sell options to protect their gains.

A gold call option is a bet by the buyer that prices will rise to a specific price. The buyer gets the right but not the obligation to buy gold at a specific price, but has to pay a premium for this, which is collected by sellers. The seller is betting against prices rising that high. If it does, he has to pay the price to the buyer, or deliver the equivalent in gold--though this rarely happens. If not, his profit is the premium. The opposite of this is a put option, where the buyer bets prices will fall and the seller is less bearish.

In the gold market, options markets are normally larger than gold futures and forwards markets, giving them a significant influence on prices. In the Comex gold market, for instance, the amount of call options on Nov. 4 totaled 42.96 million ounces, or 1,336 metric tons, nearly half the 2,416 tons produced by gold miners in 2008.

Some observers said large institutional investors who have long positions in gold futures, physical gold or gold exchange traded funds may decide to sell call options or buy puts as a hedge to protect the profits they made on this year's bull run. The amount they collect in premiums will offset losses they may incur on their long positions if gold prices correct or fail to rise as high as options predict.

At the moment, buying gold call options is the most popular strategy, indicating investors in general remain bullish on gold, said the head of precious metals trading at a large investment bank in London. There is a premium of 6% in buying one-year to two-year dated call options relative to puts, meaning investors are buying more calls than puts, he said.

But that trend could change if some investors who are already long on gold decide prices have peaked and want to protect their gains, observers said.

Clift said sovereign wealth funds, hedge funds, pension funds and ETF holders that already own a lot of gold may want to sell options to hedge the gains they have already made and thereby maximize their returns.

"No matter how strong fundamentals are, when something just goes in one direction and everyone's on the trade, it has to reverse at some point," Clift said.

Raymond Key, global head of metals trading at Deutsche Bank in London, said in coming months there will be growing use of options trading, particularly in gold ETF markets.

High net-worth individuals, who may be long on gold, either in physical metal or in ETFs, may sell more shorter-dated options with the expectation that gold prices will correct before resuming a longer-term uptrend.

Such strategies grow in popularity when "the market is going up in a straight line" and investors who are long on gold want to take advantage of corrections or consolidation phases, Key said. "It would temper the rally," he said.

Another choice available to these investors is to buy puts, betting that prices will fall and again hedging their long exposure, said Jeffrey Christian, managing director of U.S. based commodity research and consultancy CPM Group.

Even if the gold price does not decline to the specific price of the put, the value of the put will increase as the gold price draws closer to the option price, and the investor can sell his put back for a profit, Christian said.

While this may not necessarily push prices significantly lower, it could stimulate options trading, and this often exaggerates price movements, he said. "If they did sell, they will accentuate the decline in prices."

Source: COMMODITIESCONTROL