Last week Christopher Diodato published a suggested trade
for entering a 2:1 call ratio spread on the Gold ETF (GLD
The trade? Buy one October 180 call and sell two October 190 calls. As of Friday, that trade could have been put on for a net credit of 10 cents – or $10 per contract. The potential reward? $1100, but that’s only if GLD is exactly at 190 on expiration day.
Christopher mentioned that the maximum loss of the spread is $151 per spread. That may be true if he watches his stops, but be forewarned, this an unlimited risk trade. Selling two calls against one long call means having a naked short call position. That’s not for timid, and at most brokerage firms (if not all), it requires the highest level of trading privileges and posting a hefty margin.
Is it worth it?
Here’s a look at how this spread could make a limited amount of money or lose a lot of money depending upon how GLD trades until expiration -- using 10 longs calls and short 20 calls as an example (a 1x2 ratio call spread)
The position provides an initial net credit of $1000 and benefits from time decay if GLD rises to near 190 but doesn’t move much higher. Note that it will take weeks to realize the full value of the trade. If GLD spikes, losses mount quickly and quick action will be needed.
Also, Christopher says he is basing his trading hypothesis on the notion that $2000 per ounce represents a psychological resistance barrier. But note that because GLD lags actual gold (from expenses deducted from the fund), if GLD trades at 200, it means that gold itself would be trading north of $2050 – maybe a bit higher.
Selecting another ratio
I don’t care for this type of trade because it requires precision for both price and time. But if you feel compelled to set up a ratio spread, consider a variety of different ratios.
Take a look at this chart. It shows the profit from a spread using the same strikes, but adjusting the ratio from buy 10/sell 20 to buy 14 /sell 19
If I were forced to choose between the two, I’d go with the buy14/sell 19 version.
Although this spread also has unlimited risk and poses actual downside risk (because of its initial $1660 net debit instead of a credit), it delivers more profit more quickly at a wider price range than the buy 10/sell 20 spread. And the unlimited losses don’t start kicking in until a much higher price for GLD because there are fewer naked short calls compared with long calls.
Let me be clear one more time. I don’t find either of these unlimited risk call ratio spreads to be particularly appealing. I just wanted to point out that when it comes to ratio spreads, you don’t have to be confined to round numbers like 2:1 when other ratios might offer more attractive payouts if the underlying moves the way you think it will.
Disclosure: I am long GLD.