A Risky (But Rewarding) Option Trade

05/05/2011 6:00 am EST

Focus: OPTIONS

Traders can capitalize on the overheated nature of gold ETF GLD by executing a call ratio spread, but there are some important risks to manage, and this is not a trade for the faint of heart.

Anytime SPDR Gold Trust (GLD) gets extended, I like to revisit one of my strategies of choice for playing tops: the call ratio spread. The beauty of the trade versus shorting stock outright is the wider profit zone and larger margin for error. It offers a position that profits if the stock declines, stagnates, or even rises mildly. 

Right off the bat, let me say that trying to play a top in any stock, future, or commodity can be a very risky opportunity. Strong trends, such as the one in gold, have decimated the accounts of traders who have tried to predict and trade a reversal. This trade is not for the risk-averse or faint of heart, but if there ever was a contrarian trade, this is it.

Suppose we entered a May call ratio spread by purchasing one May 150 call while selling two May 152 calls for a $1.05 net credit (at the time of this writing—be sure to check current pricing before entering any trade).

Ideally we see a strong rise in implied volatility concurrent with a strong upswing in GLD. This mad dash for scooping up out-of-the-money call options bolsters their extrinsic value and may even increase the volatility skew as you move from strike to strike.

As of last Friday (April 29), we hadn’t seen much of an uptick in demand for GLD options, however, that has started to change a bit in the last few days. While this low demand dampens the appeal of the call ratio spread, I still think it’s worth a look to those inclined to make a contrarian bet on gold.

This trade is structured to profit in three scenarios: 

  1.  A drop in price
  2.  Sideways movement
  3.  Slow drift higher

Since the position involves short naked calls, the major risk is the chance that GLD rises too quickly.

Here are three suggestions for how to manage the ratio spread if GLD does rise too quickly, listed from simplest to most complex:

  1. Set a pre-determined exit point to close the position altogether. Identifying the exit point comes down to personal preference.

    The simplest is to probably use the dollar amount of the loss. If you’re willing to risk $300 in the trade, then bail once you hit $300. If you only entered one spread, then you may be able to give the trade a long leash. If you entered with a lot of contracts, then you will have to bail much quicker.

  2. You may also consider using the Delta of the position. It starts off close to Delta-neutral but acquires negative Delta at an increasing rate as the stock lifts. If you reach a point where the Delta is too high, leaving you uncomfortable with the amount of directional exposure, close the trade.

  3. Instead of closing the trade, some opt to make an adjustment. Two adjustments you may consider are closing part of the position or rolling the short calls further out of the money (OTM).

As far as the first one goes, if you entered two 1×2 ratio spreads, then close one of them. You immediately cut your remaining exposure in half. An example of rolling further out of the money (OTM) would be closing the short May 152 calls and selling the May 153, 154, or some other higher strike price. This also reduces your Delta exposure, but leaves you open to additional upside risk if the bull run remains in force.

Keep in mind the original trade idea is based on the premise of wanting to play some type of short-term top in GLD. Those of the opinion that commodities are a one-way freight train shouldn’t be entertaining thoughts of calling tops anyways.

My main point here is that I usually prefer the call ratio spread over shorting stock, buying puts, or selling vertical call spreads when playing an overextended market or security.

By Tyler Craig of TylersTrading.com

Related Articles on OPTIONS