The following is a guest post from Christopher M. Uhl, CMA, MOSM, Editor of 10MinuteStockTrader.Com. Today he shares his thoughts on the precious metals markets. In the past he has shared his thoughts on various VIX ETPs, some of which melted down recently.
Gold may be on the verge of a breakout, but then again maybe not. Wouldn’t it be great to be able to make a high probability trade while still maintaining unlimited profitability? Here is a new trade that I’ve been implementing this year that has proven itself time and time again to deliver on its high probability of profit, small defined risk, and undefined profit potential.
I call it “The Better Call.” With a traditional Call option, the buyer has to wait until the Call strike they’ve purchased goes in the money, plus the amount they paid for the Call, for the trade to be profitable. With the Better Call, that’s no longer the case.
This is a three-legged trade where we start by selling an out of the money Put spread at around the 30-40 delta. This trade on its own is a high probability setup. With the deltas being an approximate gauge of being in the money at expiration, this trade starts with a probability of profit between 60-70%.
Now we take the credit from the sale of the Put spread and buy a long Call with those funds, but the long Call must cost less than the amount of credit received. By buying the long Call and leaving a credit, the breakeven stays below the short Put spread yet gives us the opportunity to have significant profit potential if the long Call goes into the money.
Let’s look at a real trade example of this setup. As of May 30, 2018, the Gold ETF (SPDR Gold Shares: GLD) had a closing price of $123.41. Going into the July 2018 cycle, we can sell the $122 Put and buy the $121 Put for a total credit of $31 per put spread. The $122 Put has a 36 Delta, so right off the bat, this is a high probability trade with an approximate probability of profit of 64%.
However, the profit is defined with this trade and limited to only $31. We can then take our credit and buy a long Call at the $132 strike for $23 and are left with a credit of $7. This $7 might not sound like much now, but if all the strikes expire out of the money, then we still have a 7.2% (7/93) return on capital in only 50 days, which is not too shabby on its own.
This trade also benefits from an increase in volatility. Gold has inverse skew which means that the Calls are priced higher than the Puts because investors see more upside risk than downside risk. The current implied volatility rank is only 26, meaning that the current option prices are only at 26% of the highest option prices over the last year. If volatility rises, our long Call will expand in price, leading to even greater profits in the early days of the trade. Although, if held to expiration, profits and losses will be derived solely from the difference between the market price of GLD and the strikes on the options traded.
If Gold does breakout, this trade can show significant profits and be managed in several ways. First, we could close the Put spread, removing all risk if the debit to close the spread is less than the original credit received and still keep a free long Call. We can also roll up the Call to take in additional credit and offset any risk if we haven’t already closed the Put spread. Or we can let GLD run and then close at expiration and take our profits where the price falls.
If Gold decides that it would rather tank than soar, the losses in the trade are limited to the width of the strike minus the credit received. The breakeven of the trade is $121.92 and the total risk is only $93.
Only time will tell which way Gold will go, but of the three possibilities, up down or sideways, we’ve got each of them covered with a 65% probability of profit. Now doesn’t that sound like a Golden Opportunity?
The opinion presented above is provided by Contributor Christopher M. Uhl, CMA a guest contributor and editor of 10minutestocktrader.com. Mike & I encourage guest contributors to write articles and give an opinion that may or may not agree with ours. We believe a discussion of the issues both pro and con will serve to improve our reader’s decision-making process. In addition, guest contributors may explain an option structure (like the short put-spread risk reversal discussed above) differently than the way we might. If that helps our readers understand the strategy better, we view that as a positive.
Image Source | Michael Steinberg, Pexels.Com
