Based on large university studies of options spreads, ratio spreads, over time, offer the highest rate of return of all option strategies. Still, I prefer to wait until the perfect time to initiate them. What is the perfect time? As David Kaplan, option wizard, states, the best time to initiate a ratio spread is “right after a sharp upward price movement loses momentum.” That was today with gold, with the first “breather” since the rally’s start 10% ago.
The rally succeeded in driving option premiums to 2-year highs, giving option sellers an enormous advantage in the market. The far “out of the money” options are especially overpriced. Since we are here only to make money, why not take advantage of this disparity?
Since I see the gold price of $2000 as an extremely significant psychological anchor (people tend to place sell orders at “nice” round numbers), I want my breakeven to be slightly above that price. In addition, while waiting for time decay, I don’t want to have to deal with large unrealized losses, so I want a large distance between the strike prices of the options I buy and sell. My conclusion was to buy the October 180 GLD call and to sell double the amount of October 190 calls.
Risk management is important with these trades, since we technically have unlimited risk. Our plan is as follows
- August 11-Sept 11: Exit if the price closes above 180
- Sept 11-Oct 11: Exit if the price closes above 190
- Oct 11-Expiration: Exit if the price closes above 200
This trade gives us the following
- Max gain – $1056 per spread
- Max loss – Using option pricing models, I get $151 per spread
- Percent chance of profit 90%
- Risk/reward: I don’t know how I could calculate this, but tomorrow I am going to start a project using integral calculus to get an approximation.
Note: You may want to watch this video in full screen and high definition. Remember to have plenty of cash to fulfill the margin requirement.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GLD over the next 72 hours.