Wednesday, 30 April 2014

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.

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

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:

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
 $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
$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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