Tuesday, 29 April 2014

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. 


  1. Nice analysis Mike. Look forward to more posts.


    1. Thanks Sam, I wrote a post on the put side structure as well. Check it out at: http://optiontronic.blogspot.com/2014/04/gold-better-way-to-go-long-part-4-put.html