The Right Tool for the Right Job - Part 1

09/09/2013 8:00 am EST

Focus: OPTIONS

The beauty of options is that there are multiple ways to take advantage of further upside moves while limiting risk, writes Russ Allen of Online Trading Academy.

Recently the equity indexes reached all-time highs and then pulled back (as of August 22) by about 4%. Meanwhile, the price of gold seemed to have bottomed out at multi-year lows in June, and has recovered about a quarter of what it had lost since it made its 2011 highs.

Investors in both gold and equities had reason to be bullish but cautious. Options strategies give us multiple ways to take advantage of further upside moves while limiting our risk. When choosing a strategy, we should be aware of the different ways to accomplish what we're trying to do.

Let's look at the gold ETF, GLD. Its chart is shown below. As of August 22, it stood at 133.15. It was rising into an area that had been the origin of the last major down leg in June.

Figure 1 - GLD

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Although the trend was strong, the significant resistance at this level was worrying to gold investors. If the price did break through this level, it looked as if it could reach around 140 within a few weeks.

Was there a way for an investor who already held GLD to preserve most of the profit gained to this point, and still participate in a further move if it happened? Would I have asked the question if not?

One way to gain a limited amount of downside protection is to sell call options against the long position. On 8/22 we could have sold the September 140 calls for $.71. This would in effect reduce our cost of the GLD position by $.71 per share. We could then withstand a drop of up to $.71 without losing any of our profits to date. If GLD did continue up, we would still participate, up to the $140 strike price. When the September calls expired, we could then sell more calls at higher prices, and so on. Covered calls are a great income-generating device, and they do help us to whittle away at our average cost month after month.

All of this would only make any sense if we expected GLD to continue moving up. If we didn't believe that it would, of course, we would simply sell it, pocket our profits, and not bother with any of this.

An investor who was only mildly apprehensive might be satisfied with that $.71 of extra cushion. But GLD has shown it is quite capable of making breathtaking drops much larger than that. A covered call provides only very limited protection, in the form of cost reduction. We are still exposed to drops that are larger than that. Could we do anything to get more protection?

One popular way to do just that is by using a collar. In this strategy, we use the cash generated from selling calls, to help us pay for an insurance policy. This insurance is in the form of put options. We could have bought September 130 put options for $1.94 per share. This would guarantee that if GLD made another of its gut-wrenching drops, we would always be able to sell at no less than $130. This would limit our loss to no more than the current price of $133.15, less the guaranteed resale price of $130, or $3.15. We would be paying a net price of (put premium minus call premium) = ($1.94 - $.71) = $1.23 for this insurance.

NEXT PAGE: The Payoff

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In the worst case, we could lose the $3.15 in addition to the $1.23 net insurance cost, for a net loss of $4.38 per share. We could not do worse than that, even if the price of GLD dropped to zero. You could say that our net premium for our insurance policy was $1.23, and the deductible on the policy was $3.15.

Below is a payoff diagram of a collar position with these components. The individual option prices and other data are at the bottom of the diagram.

Figure 2 - GLD Collar diagram

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Notice the Max Gain-Loss columns under the diagram. With this position, our maximum loss was $438 per hundred shares of GLD, or about 3.3% of its $133 price. We would incur this max loss only if GLD were below $130 at the September expiration.

If GLD stayed put, the call and the put would both expire worthless. In that case we would have paid the $1.23 for our insurance policy, and not had to "make a claim" (sell our GLD at a further loss of up to $3.15).

If GLD did continue up, we could make up to a maximum profit of $5.62 per share. Having sold the 140 call, we would be obligated to sell the stock at $140. This would represent a gain of $140-133.15 = $6.85. From this, we have to subtract our $1.23 net insurance cost, leaving $5.62.

If you're familiar with option payoff diagrams, you may have noticed that the one above looks just like another familiar one - the bullish vertical spread. In fact, it is the equivalent of exactly that - a 130-140 vertical spread. The long stock plus the long 130 put together are the synthetic equivalent of a long 130 call. That long 130 call, plus a short 140 call, would together be a Bull Call Spread.

Below is the payoff diagram for the bull call spread:

Figure 3 - GLD 130 - 140 Bull Call Spread

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Click to Enlarge

Note that this spread gives almost the same max gain and loss-$596 gain and $404 loss-as the collar's $562 and $438. Its diagram is nearly identical to the collar, as is its P/L at any price of GLD. A major difference, though, is the capital tied up in the two positions.

The collar ties up the whole $13,315 value of the 100 shares of GLD stock; plus the net "insurance" cost of $123, for a total of $13,438.00.

For the bull call spread, we need only $475 to buy the 130 call, and from that we can subtract $71 received from the sale of the 140 call, for a net out-of pocket cost of only $404.00.

Given these alternatives, it seems obvious that a good move would be to sell out our GLD at its current price, pocketing $13,315; and then buy the bull call spread with just $404 of that money. We'd retain the same upside and limited risk as if we had used the collar. We'd also get to collect interest on almost  $13K of cash, or use it elsewhere in another position.

The last difference is this: The options expire, and GLD does not. If we use the collar, we would probably still have the GLD stock in our hands after expiration. With the bull call spread, we would just have cash. Same profit or loss, just a different configuration of our portfolio when the options expire.

By Russ Allen, Instructor, Online Trading Academy

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