Options – Anchors and Offsets, Part 3

June 27th, 2014
in contributors, syndication

Online Trading Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

In some recent articles, I’ve talked about the idea of anchors and offsets in options strategies. This ability to add precisely-metered offsetting positions to fine-tune a strategy is unique to options. Doing it correctly is part art and part science. Choosing the right combinations from the nearly unlimited array of possibilities is what we teach in our options course. In these brief articles, I can give some brief examples, like this one:

Follow up:

As this is written on June 19, the price of gold has just gotten a nice boost. After moving relentlessly lower for the last three months (within the context of a bigger down trend that’s now three years old), it suddenly popped up to a price solidly above its 52-week moving average. The reasons appear to be geopolitical concerns, together with statements from the US central bank indicating that interest rates will not rise to rates as high as had earlier been forecast. Low interest rates are good for gold prices.

On this chart of GLD, the exchange-traded fund that tracks the price of gold (one share = 1/10 ounce of gold), we can see that a previous swing high at $126.63 was broken, and the next major swing high at $128.25 is within range:


The indicator at the bottom of the chart displays implied volatility (IV), which is a measure of the expensiveness of the time value contained in the prices of GLD’s options. IV was showing a reading of 11.5%, a multi-year low; this had not yet been updated for the volatility change that had happened on this day, which would take IV up to around 13%. That change is drawn in in purple at the end of the indicator. At this 13% level, IV was still quite low, meaning that options were still quite cheap.

Let’s say, for the sake of argument, that we believe that gold has now gone into a bull phase that is going to last for some time and move the price much higher – that we believe that GLD might reach its 52-week high around $133 within the next month or so. We would like a leveraged way to profit from that $7 (or roughly 6%) increase.

First, as always, the simplest possible bullish option strategy is just to buy calls. These will go up in value in concert with the price of the stock. We could have bought the September $126 calls for about $3.85. Below is the option payoff chart for the long call position. The dark blue line represents the profit or loss (vertical axis) 30 days from now given any price of GLD (on the horizontal axis). This takes into account the drop in the option’s value over a 30-day period due to the passing of time; and assumes no change in IV.

If the increase to $133 materialized in a month, those calls would go from their current value of $385 per contract to about $761, for a profit of $3.76 (96%). If instead of moving up, gold was unchanged a month from now, then the calls would lose about $.58 of time value (-15%). The maximum loss would be at a GLD price below about  $113, at which point they would be a near-total loss (-$3.80 per share or -100%).

If IV increased in the next month, it would help the position considerably, since we are long time value. The average IV reading over the last year for GLD was about 20%. This is half again as much as the current reading around 13%. If IV increased to that level, then the P/L picture would look like this:

With that increase in IV, the P/L at the $133 target would be $470 or 122%; at an unchanged price of GLD it would be +$70 or 18%. The increase in IV would account for a $128 increase in the price of the calls if GLD were unchanged, which would more than offset the $58 loss due to the passage of time. And at a GLD price of $113, not quite all of the time value would be lost.

OK. Now what about an alternative position?

Since IV is pretty low but not at absolute rock bottom any more, we might consider a bullish calendar spread. In this position, we buy a call option with a strike price at or above our upside target ($133 in this case). This one will have an expiration date at least three months in the future. Simultaneously, we sell, as an offset, a call at the same strike but an earlier expiration date.

We hope that the underlying asset moves up in price, but not beyond the strike price by the earlier expiration. If that’s true, then our long-term call will be more valuable than it is now; and the short term call will be gone, having expired worthless. We can then sell the long-term call at a profit, having also kept all of the money received for selling the short-term call.

We will also benefit if IV increases between now and the short-term option’s expiration. An increase in IV will make our long-term option more valuable. It will make no difference to the short-term option, as long as that option expires worthless. So the higher IV is at the short-term expiration, the better we like it.

As of 6/19, we could have bought the September 133 calls for $1.33, and sold the July 133 calls for $.32. Our net debit would be $1.33 less $.32, or $1.01. Here is the payoff graph and stats for that trade:


Click to enlarge

The $101 debit would be our maximum loss, and would occur only if GLD were below about $105 at the July expiration. If GLD were unchanged at $127, our net loss would be just $6.45 (6 cents a share, or 6%). And if our $133 target were hit, our profit would be $211, or 210%. Since these spreads cost about a quarter of the $385 cost of each 126 long call, we could do about 4 times as many spreads for the same total dollar risk.

If IV increased back to its average by the July expiration, then this position would fare better, as shown here:


Click to enlarge

Maximum profit would go up to $367 on $101, or 363%.

Profit with GLD unchanged would be $117, or 116%. Let me say that again: if GLD remained unchanged, we would still make 116% on our money if IV increased back to its average.

Here is a table comparing the long call with the bullish calendar:

Once again, the power of options used in combination is striking. There is just one thing that the above table does not show: for the calendar, the total profit is limited. For the long call alone, it is unlimited. This can be seen by the shapes of the P/L curves in the diagrams above. If GLD goes clean out of sight, the long call option would prove to be superior. But anywhere short of that, the bullish calendar will turn out to be a better use of capital.

I hope this demonstration of the power of using options in combination has inspired you to investigate it further.










Make a Comment

Econintersect wants your comments, data and opinion on the articles posted.  As the internet is a "war zone" of trolls, hackers and spammers - Econintersect must balance its defences against ease of commenting.  We have joined with Livefyre to manage our comment streams.

To comment, just click the "Sign In" button at the top-left corner of the comment box below. You can create a commenting account using your favorite social network such as Twitter, Facebook, Google+, LinkedIn or Open ID - or open a Livefyre account using your email address.















 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2016 Econintersect LLC - all rights reserved