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OPTION TrAdINg STrATegIeS
 2. buy spot gold. The jeweler can buy spot gold and store it until August. In this case, he locks 
in a purchase price of $1,198.90/oz plus carrying costs (interest, storage, and insurance). This 
approach eliminates price risk, but also removes the potential of benefiting from any possible 
price decline.
 3. buy gold futures. The jeweler can purchase one contract of August gold futures, thereby 
locking in a price of $1,200/oz. The higher price of gold futures vis-à-vis spot gold reflects the 
fact that futures embed carrying costs. Insofar as the price spread between futures and spot gold 
will be closely related to the magnitude of carrying costs, the advantages and disadvantages of 
this approach will be very similar to those discussed in the above strategy.
 4. buy an at-the-money call. Instead of purchasing spot gold or gold futures, the jeweler could 
instead buy an August $1,200 gold futures call at a premium of $38.80/oz. The disadvantage of 
this approach is that if prices advance the jeweler locks in a higher purchase price: $1,238.80/
oz. However, by purchasing the call, the jeweler retains the potential for a substantially lower 
purchase price in the event of a sharp interim price decline. Thus, if, for example, spot prices 
declined to $1,050/oz by the time of the option expiration, the jeweler’s purchase price would 
be reduced to $1,088.80/oz (the spot gold price plus the option premium).
6 In effect, the pur-
chase of the call can be viewed as a form of price risk insurance, with the cost of this insurance 
equal to the “premium.”
7
 5. buy an out-of-the-money call. As an example, the jeweler could purchase an August 
$1,300 gold futures call at a premium of $9.10/oz. In this case, the jeweler forgoes protection 
against moderate price advances in exchange for reducing the premium costs. Thus, the jeweler 
assures he will have to pay no more than $1,309.10/oz. The cost of this price protection is $910 
as opposed to the $3,880 premium for the at-the-money call. In a sense, the purchase of the 
out-of-the-money call can be thought of as a price risk insurance policy with a “deductible.” As 
in the case of purchasing an at-the-money call, the jeweler would retain the potential of benefit-
ing from any interim price decline.
As should be clear from the above discussion, options meaningfully expand the range of choices 
open to the hedger. As was the case for speculative applications, the choice of an optimal strategy will 
depend on the trader’s (hedger’s) individual expectations and preferences. It should be stressed that 
this section is only intended as an introduction to the concept of using options for hedging. A compre-
hensive review of hedging strategies would require a far more extensive discussion.
6 T echnically speaking, since gold futures options expire before the start of the contract month, the effective 
purchase price would be raised by the amount of carrying costs for the remaining weeks until August.
7 The use of futures for hedging is also often described as “insurance.” However, in this context, the term is 
misapplied. In standard application, the term insurance implies protection against a catastrophic event for a cost 
that is small relative to the potential loss that is being insured. In using futures for hedging, the potential cost is 
equivalent to the loss protection. For example, if the jeweler buys gold futures, he will protect himself against 
a $10,000 increase in purchase cost if prices increase by $100/oz, but he will also realize a $10,000 loss on 
his hedge if prices decline by $100/oz. In this sense, the use of the call for hedging comes much closer to the 
standard concept of insurance: the magnitude of the potential loss being insured is much greater than the cost 
of the insurance.