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Options

Options are very similar to future contracts for gold investments. They are derivative instruments that give their buyers the right, but not the obligation as with futures, to buy or sell a given instrument or asset (like gold) for a price set today on a specified day in the future. Option sellers, however, do not have a choice and like with a futures contract have to take part in the transaction, if the buyer wishes so.

There are two types of options – call options and put options. Call options give their buyer the right to buy and put options the right to sell the instrument they are based on. The majority of options have an expiration date, after which they become invalid and worthless.

The option buyer profits if the price of gold goes in the assumed direction. Otherwise the option expires unexecuted, since executing it would be unprofitable. The option seller, on the other hand, profits if the buyer doesn’t execute the option. The seller’s profit is the premium which the buyer paid to buy the option or simply its price.

The option buyer has thus unlimited profit potential and limited loss potential. Potential profit depends on the behavior of the instrument (such as gold) the option is based on. On the other hand, the option seller, its writer, has unlimited loss potential and limited profit potential. The only possible gain for an option seller is the premium the buyer paid buying the option. This is one of the reasons why options are relatively expensive, usually more expensive than futures contracts.

Another advantage is that buying options doesn’t involve such heavy costs as buying physical gold, which can theoretically make them better for individual investors that have small amounts of money. Fees associated with options are not very high. In addition, like futures they are very liquid. They can be bought or sold on many exchanges. Apart from speculation or investment they can also be used as a hedge against unfavorable price fluctuations.

From the writer’s point of view, the fact that writing options involves unlimited potential losses and very limited profit potential may be considered a serious drawback. That can make them a very risky instrument for issuers, unless they own the asset the option is based on – in this case we can call it hedging.

Options are financial instruments that are extremely hard to value. Their prices are influenced by a variety of factors, like the base instrument price, option exercise price, base instrument volatility or the risk-free rate. Since options are very sophisticated they may be hard to understand for beginning investors.

Buying options also involves other risks that in the short run may not be of significance but in the long run should be taken into account. An example may be the change of derivatives market rules and regulations. Although there is no need to maintain a margin with options, unfavorable changes may theoretically affect those investors that trade options.

Investing in options also carries the risk that the other side of the contract may not fulfill their obligation. This risk is not very significant since the options market is regulated and controlled, but it still exists. A financial crisis may cause gold prices to increase, which can give option holders large profits. It can also, at least theoretically, lead to options exchange bankruptcy and prevent the investor from executing options and thus from profiting. That is why, just like with futures, options are especially attractive for traders or as a tool for hedging other positions. They are, however, not suitable for long-term investors.

Options on futures

Apart from options on physical gold there are also options on gold futures contracts. They give the right to buy or sell a specified contract on a specified day for a price set today.

Buying options on futures can be considered more advantageous than buying futures alone. Options on futures provide more flexibility – options give the right, not the obligation, to buy the futures contract, which means that in the event of unfavorable price changes they do not have to be executed. They also give higher leverage than futures alone – buying them can significantly increase potential profits while reducing potential losses.

Options can be bought or sold on exchanges. The most popular exchanges offering them are the New York Mercantile Exchange (NYMEX) and the Tokyo Commodity Exchange (TOCOM). Options listed on the NYMEX are denominated in dollars per ounce of gold and the ones listed on the TOCOM in yens per gram of gold. In order to trade them, however, it is necessary to use the services of a brokerage firm and have a brokerage account.

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Dear Sunshine Profits,

gold and silver investors MARCH 15TH, 2011
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