Gold - A better way to go long? (Part 4 - Put Side Structure)

GLD trading down half a percent at close today (4/30). Before we get into financing the call side with a put structure, let's look at what would have happened to various long positions from yesterday when GLD was trading at $125.03 (Part 3). *all options are from June monthly series.

Structure	Cost Basis	Current Liquidation Value	P/L	Margin Requirement
100 GLD Shares	125.03 x 100 or $12,503	124.22 x 100 or $12,422	-$81	$12,503
1x 125 (ATM) Call	$2.70 x 100 or $270	$2.26 x 100 or $226	-$44	$270 yesterday
135 140 Call Ratio	$0.06 x 100 or $6	No change	0	$1250
135 140 145 Fly	$0.11 x 100 or $11	No change	0	$11

As you can see, the deltas on the call ratio and fly is very slow. So we are much more buffered from gold falling than going long shares or higher delta calls. However, in exchange for this buffer we won't make any money unless gold moves closer to our long strike at 135. If you are absolutely convinced gold will move up sharply over the next 50 days or so, then you'd be better off picking a much more aggressive position such as buying high delta calls. But as you can see, if you are wrong you stand to lose much more. Even if you believe the macro conditions are ripe for gold to move up, it is exceptionally hard to predict short term trends in asset prices. Unless you subscribe to a newspaper of tomorrow, I recommend caution and structuring slow delta positions. 

As I mentioned in Part 2

"So the idea is to design positions around realistic trading bands of gold, while structuring risk exposure on both sides so that:

a) We can receive credit upfront for the entire structure, ensuring if GLD doesn't move or moves slightly the wrong direction, we still have an opportunity to profit. 

b) so we can manage the position in separate legs, giving us flexibility to extract profit from certain parts of the position as GLD moves around"

Now it's time to structure a put credit spread so we can receive a net credit for the trade initally. I don't use alot of technical indicators but I think it's important to look at major support levels on a 1 year chart.

Call me crazy but I think there's a pretty strong support level at the $115 level. Let's do some basic option maths. With underlying price @ 124.22, IV priced at 14.36% and expiration 52 days away, $115 is about 1.4 Standard deviations away.

As of today's close the June 115 strike is paying about $0.41, which basically makes your break-even for GLD at $114.59 by expiration (just slightly above the 52 week low) if you were naked short the puts (for the record I am short 10 contracts at this level and I sold it at about 70 cents). 

Let's quickly outline some reasons why I believe this is the lower trading band of Gold for the next little while.

a) 1 year chart is showing pretty strong support levels at the $115 level

b) don't forget we are actually bullish on gold due to the situation in Ukraine

c) 1.4 STDev isn't terrible close even in option terms

d) Remember gold isn't a stock, there's intrinsic value in gold. it's not going to be affected by surprise events like bankruptcies, corrupt CEOs, and crooked accounting. Gold doesn't have fake CDOs on worthless properties on its balance sheet :) So gold won't drop to 0 overnight.

e) There's an extraction cost for gold. It ranges widely but all-in extraction cost for some of the largest gold miners range from 900 to 1100$/oz. This doesn't guarantee a bottom for gold but it does guarantee that if prices do drop, the forces of diminishing supply as miners shut down operations vs. demand will pull the prices back up. Here's some great info-graphics on gold: http://www.visualcapitalist.com/what-is-the-cost-of-mining-gold

f) in terms of macro events, the feds are tapering and have made it very public that they'll continue tapering. so the $10b/month should be priced in. they have also repeated stated short term rates will say near 0 for the next while. by the expiration of our structure in June, QE would still be in the tapering phase. It's highly unlikely a rate increase will be in the books by that time.

for all of the above reasons, I am fairly comfortable having a short position at those strikes. now remember the 2 structures from yesterday.

the 135 140 call ratio cost a net debit of 0.06$
the 135 140 145 butterfly cost a net debit of 0.11$

we can do a couple of things here to finance the debit on the call side.

a) naked short 115 put for 41 cent credit (10.5 deltas)
b) short 115 113 put spread for 13 cent credit (barely 3 deltas)

here's a summary of potential GLD structures

Structure Call Side	Structure Put Side	Initial Cost	GLD between 115 and 135 by expiration	Max Profit	Max Loss	Margin Requirements
135 140 Call Ratio	Short 115 Put	35 cent credit	$35/spread	$5 dollars + credit or $5.35/spread if GLD @ 140 by expiration	Unlimited on Call Side if gold rises to infinity by June 21 $114.59 if gold falls to 0 by June 21	High (portfolio margining pretty much required)
135 140 145 Fly	Short 115 113 Put Spread	2 cent credit	$2/spread	$5.13/spread if GLD @ 140 by expiration	$200 per spread if GLD below $112.87 by June 21	$200 per put spread

The first structure is more risky, but allows you to keep at least 35 dollars a spread if GLD ends up anywhere between 115 and 135, and up to $535 a spread if it ends up at 140, you'll suffer no loss until GLD goes past 145$. so your profit range spans a $30 range. on the other hand you can suffer an unlimited loss. 

The second structure is much less risky, but basically pays nothing starting out. you can only profit if GLD moves up close to 135 by expiration. max profit is essentially the same but max loss is $200/spread if GLD falls sharply below 112.87 by June 21.

You can also leg out of your positions and eliminate downside risk as GLD moves up (for instance if GLD moves up a couple of dollars and your short put falls by 20 cents. you can close your puts and leave your fly), or take profits on your short calls as GLD moves down (closing your short calls leaves you a pure long otm position, giving you unlimited profitability as GLD moves up). It is flexible and can be adjusted numerous ways. We'll get to these adjustments when the time comes! Also I didn't talk about the Greeks of this position much. If you are interested in the technical details and how to manage by adding or subtracting greeks let me know and i'll incorporate more of that into the next discussion. It's a bit more abstract but can be a great way to manage your positions as it becomes more complex. 

By the way, this is simply a trade analysis, not a recommendation. 

Bonus:  here's a more aggressive structure.

The put side is still at 115, and you are using the credit to slightly finance the 2:-3 call ratio. with these strikes you'll start profiting up to a maximum of $6 if GLD ends up at 136 by expiration. your break-even is at 142 at expiration (since your 133s will be 9 dollars ITM x 2, and your 136s will be 6 dollars x3, both will be 18 dollars ITM resulting in a net $0 position). However you'll end up making money faster if gold rises since your long strike is at a lower strike (133 vs 135), and you are now long 2 calls instead of the 1 call in the 135 140 ratio.

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Gold - A better way to go long? (Part 3 - Call Ratio Structure)

GLD is trading at 125.03. Pretty much where it was on Friday close. In Part 2, I mentioned the call forward ratio. Let's take a look at this structure in depth.

First, the June monthly options with strikes labelled with the standard deviation calculations from part 2.

There are many ways to structure a 1:-2 call ratio with a break-even at expiration at 144. The most important is determining the width between the long and short strikes. This will affect both max profit and how risky the position becomes.

I typically would want at minimal a 1.5SD range to profit in. Take a look at the simulated position. Ignore the +1 position at the 145 Strike for now. If we were to setup a long June 135 and short 2x 140, we will have a $5 spacing between the long short strikes. I'll list some of the features of this structure below:

Long 1 @ 135
Short 2 @ 140
Distance between long and short strike = $5
Break-even @ Short Strike + distance between strikes = 140+5 or $145 (more than 2.6 SD away)
Max Profit @ Expiration = short strike - long strike = 140- 135 or $5 per spread
Profit Range @ Expiration = BE - long strike = 145 - 135 = $10 (1.5 SD profit range)
Buying 14.92 volatility (on the 135 strike) and Selling 16.48 volatility (on the 140 strike)
Net cost assuming mid pricing: 0.30 - (2)(0.12) = 0.06$ debit

Now if we setup the 135, 140 call ratio, the margin will be high. notice you are essentially short 1 set of uncovered 140 calls. the margin req on some accounts it'll be higher than others. But on t-reg accounts you'll be held at a minimal of 10% of underlying price. So with GLD trading at 125, you'll be held a minimal of 0.1*100*125 or 10*125 or 1250$ per 1:-2 spread. If you are on a smaller account, this is going to be prohibitive. So one way to reduce margin (to make it 0 margin req) is to just cap off your upside risk.

Notice the 1x 5c option at the 145 strike? That's if you want to cap off your margin. This makes the position a long butterfly. It'll increase your net debit to 0.11$ debit but you'll have 0 margin requirements. It doesn't change the way the trade works drastically, but it'll cap off your margin requirements. It'll also completely take away your upside risk. However one downside is you no longer have as big of a volatility skew advantage since you bought a 18.09 volatility option but was only able to sell 16.48. Since the option is only 5 cents right the effects are very small.

If GLD moves up a little bit and you have a larger account, you can hold off making it a long butterfly and just insert another symmetrical ratio above the existing position. For example if GLD rises to 135 and you want to extend your break even further, you can go long 1x 145 and sell 2x 150. you'll take in more credit and extend the break-even to 150. However, you'll be short uncovered 2x 150, which will result in a minimal of 10%*underlying price *200 per 1:-2 ratio on t-reg accounts. So make sure to calculate your margin requirements correctly before you put on positions, the last thing you want is to put on these positions are have no room to adjust. There are also other ways to adjust upwards and take profit as GLD moves up, we'll explore those options when the time comes.

In Part 3 we'll look at how to finance this ratio or butterfly spread by structuring a short put position. 

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Gold - A better way to go long? (Part 2 - Upside Risk)

In Part 1 we looked at some basic stats for GLD options and developed an upside bias. However, outlook does not always translate into reality! One of the advantages of structuring positions using options vs. solely equities or futures is the ability to profit even if the underlying does not move or move in the opposite direction versus your original bias. Before we start thinking about designing a position around our bias, let's think about risk!

If we buy 100 shares of GLD, what is the risk? Theoretically, if spot gold fell to $0/oz, GLD shares will be worthless. So the theoretical downside risk is the full amount you paid for the shares. (the downside risk is actually greater than selling an naked at the money put!) Of course spot gold falling to 0 is an extremely unlikely scenario. One may argue, in exchange for this downside risk, you are also holding a position with theoretically unlimited upside. Unfortunately that is equally unlikely. 

Of course, gold can rise to 10,000$/oz, but that would take some extraordinary loss of confidence in the current financial and monetary system. Never say never, but I don't see this scenario playing out in the near future (2-3 months). So the idea is to design positions around realistic trading bands of gold, while structuring risk exposure on both sides so that:

a) We can receive credit upfront for the entire structure, ensuring if GLD doesn't move or moves slightly the wrong direction, we still have an opportunity to profit. 

b) so we can manage the position in separate legs, giving us flexibility to extract profit from certain parts of the position as GLD moves around

The first step is to determine the upper trading band of GLD in the timeframe we want to structure the position. Since we are trading off this potential event in Ukraine, let's see what happened to GLD when sanctions were first announced a few weeks ago. 

According to Reuters:* March 6: Crimea's leadership votes to join Russia. U.S. President Barack Obama orders sanctions on those responsible for Moscow's actions in Ukraine.

Looks like it went from a low of 128.21 on Mar 7th to a high of 133.69 on March 14. IV30 rose from 14.35 to 16.65 during the same period. This means in a period of 7 calendar days, GLD moved 133.69 - 128.21 or $5.48. Based on the Mar 7 IV30 of 14.35, GLD moved a little more than 2 standard deviations (using 7 days but the IV30 volatility)! Okay, that's quite a move in a week. But GLD did retrace and a month later on April 7th, it has fallen to 124.91 at the close, well within the 1 standard deviation band priced in the options. Let's keep that in mind, we should be aware GLD can go on sharp rallies in a very short period of time. This will become important as we actively manage and adjust the position (if needed) as GLD moves around.

Let's look at the min to max within the last 90 days. GLD traded at a low of 119.46 on Jan 30 to a high of 133.69 on Mar 17. So in 45 calendar days it moved up $14.23. IV30 was priced at 16.17% on Jan 30th. This is a upside move over 2 standard deviations. Okay, we know GLD can move 2 standard deviations within 45 days with how the IV30 is priced. This all happened quite recently, within the past 90 days. 

Going off on a tangent here... I like to base my trading decision on analysis of fairly recent data. This is an arbitrary decision but in my opinion, the market today is different than the market in the past (eg. data from 2010 would be more representative of market conditions today than say.. data from the 1920s). So you won't see me going back 8 years and pulling out all the GLD data and analyze my way through every extreme move in order to establish a trading band. If I decide to set up a longer term position with LEAP options, then maybe i'll go back a few years, but for positions structured 40-60 days in the future, I tend to look back for the past 90-180 days. Once again, this is a personal preference. 

Back to the trade... let's look at the June monthly options (by Monday open 4/28 they'll have 54 days to expiration). Since the structure I have in mind will have short option positions (as well as long), I would like to keep the position gamma low. This will lead to slower (and lower starting) delta on the position as a  whole (of course if we are right about GLD direction it'll also lead to less profit, but it's always better to be cautious than believe you are right about the direction of the underlying price). In additional I would like to have positive theta, in case we are wrong and gold stays flat for the next little while. The whole thesis is to structure a position where we can profit

a) from rising GLD prices

b) GLD staying flat

c) potentially profit from rising IV or falling IV on certain legs of the structure

while

c) less risk relative to straight out holding GLD shares or Gold futures.

Before we think about positions, let's check the option skew in the June series. 

The June skew is parabolic, with further OTM calls and puts priced at higher IV. It means we can buy closer to the money options for relatively cheaper IV and sell OTM calls for higher IV. Remember, we always want to trade with the skew whenever possible while expressing our directional bias for the underlying.

Let's summarize the analysis up until this point: 
a) GLD moved up 2 STDev when US sanctions were announced the first time
b) Min to Max move in the past 3 months was over 2 STDev over a 45 day peroid.
c) we want to buy lower IV and sell higher IV calls 
d) we think IV isn't significantly under-priced or over-priced from Part 1 based on HV30
e) we have an upside bias for GLD because of potential conflict in Ukraine 

2 Standard deviation range based on Friday closing price and IV30 is 111.24 to 139.62 in 54 Calendar Days

2.33 Standard deviation range is 142
2.6 Standard deviation range is 144 

Personally I would be comfortable with setting up the position with a break even at the 2.6 Standard deviation range. If prices were actually normally distributed the probability of it moving up more than 2.6 standard deviations is less than 1%. In reality, prices are not normally distributed and there's significant tail risk. However, this is a level of risk I can tolerate comfortably. If you are more risk averse you can certainly decide on a higher break-even point.

The position I have in mind given the analysis we have done is a forward call 1:-2 ratio. It will let us take advantage of skew and start off essentially delta neutral. Since the market is not open right now, we will need to revisit tomorrow. But if the price remained around where it is right now, this is a potential position.

we'll go into depth about this position and how we can cap off the upside risk and maximize margin usage in Part 3. We will also structure the downside position in part 4 and look at the overall GLD structure. 

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Gold - A better way to go long? (Part 1 - Basic Scouting)

I'm sure many of you have been thinking about going long gold given the recent crisis in Ukraine. In general, gold is a safe haven investment. Traditionally when there's been war or uncertainty in the market, money flows into gold. However, gold is also hurt by a stronger US dollar (since Gold is priced in USD) and rising interest rates (since Gold pays no interest). So in today's complex markets is there a safer way to going long gold than simply buying GLD shares, long gold futures or picking up some physicals? Let's take a look at the options market and some important statistics! 

Friday (4/25/14) Closing Price

We can see the implied volatility (IV) of GLD for the next 30 days is 14.62% (annualized) as of 4/25/14 close. What does this actually mean? Since I use Livevol Securities as my broker, they provide the software. Here is the official definition:

IV30™: A proprietary measure of the volatility of the hypothetical 30-day (calendar days) option. It's a weighted average of two months and several strikes used to compute a vol index for each stock much like the VIX does for the entire S&P 500. 

Stated simply, it basically means the option market is saying GLD has a 68% chance of ending up between $120.17 and $130.69 within 30 days. How did I come up with those numbers?

Standard deviation calculation: 

price x volatility / Sqrt number of timeframes in 1 year = 1 Stdev 

so 125.43 * 0.1462 / sqrt(365/30) = 5.26 (2 significant digits) 

If you add and subtract 5.26 from 125.36 you will get the range $120.17 and $130.69.

Of course, to make things simpler you can always use a very handy online calculator

It's very important to understand IV, it is a critical component of my trading decision. IV is one measure of the risk priced by the market! This trading range is not what I think, not what hedge fund manager XYZ thinks, not what Gold Guru bob thinks! It is the risk premium priced into options by the actions of traders buying and selling GLD options! IV is always changing, market makers tend to increase the IV when there's alot of buying at a certain strike and lower it if there's alot of selling.

If you think GLD will trade inside this range of 120.17 and 130.69, then the volatility is over priced for you. For example, you can express this view by selling an ATM straddle or strangle.

If you think GLD will trade outside the range, then volatility is too cheap, and you can express this view by buying a straddle or strangle. 

Now let's take a look at IV in context of a year. It's definitely in the lower range. It's only ranked in the 7th percentile on a 52 week basis. Now you may think this is underpriced volatility but take a look at the HV30 (this is the actual volatility of GLD in the past 30 days annualized), and as we can see it's just 12.13%, which is actually lower than the current implied. Of course, the past is not indicative of the future but it can be a good gauge into the relative "value" of the IV (as long as there hasn't been some kind of event in the past 30 days which may distort the HV, such as earnings or some kind of important announcement). 

In general, you want to buy underpriced/fairly priced options and sell overpriced options. Based on the HV30 and price action of GLD in the past 30 days, it seems the options are not overpriced at the current IV30. This doesn't mean they are under priced either, since GLD may not move at all in the next 30 days, in that case the IV30 will be actually overpriced today. 

The next component we can look at is the net delta. 

Net delta: The overall delta position accumulated by market takers (customers) through options only for trades on the bid or offer; i.e. people getting long or short delta through options. Examples below:

Okay, so from the first scan of GLD stats, we can come to 2 conclusions.

a) the IV is fairly priced (at least compared to the HV30). so we won't be at a severe disadvantage buying or selling options.

b) the market on Friday is net long deltas, so our view of going long is confirmed by actual trades. Of course it was a strong up day for GLD but at least we know the money flowing into long delta positions is alot more than short delta positions. 

In the part 2 we will start structuring a trading position!  

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