This article originally appeared in the November issue of Registered Rep. Magazine
Gold has been on a lot of investors' minds recently. Rightfully so. After an unrelenting run-up over the summer, bullion prices ushered in autumn with a wobble that really worried gold bulls. Worry soon turned to liquidation, knocking $300 off the yellow metal's cost.
Put simply, fear. Fear of a replay of the economic upheaval seen in 2008. This time, however, investors and traders expect the U.S. dollar to strengthen rather than weaken. Much of this perception is the consequence of the Federal Reserve's announced “twist” operation. By June 2012, the Fed anticipates buying $400 billion of long-term Treasury securities, financed by the sale of a like amount of short Treasuries from its balance sheet.
The Fed's action should put downward pressure on longer-term interest rates while raising yields on shorter maturities. It's a nation's short rates that makes its currency attractive to foreign exchange buyers, so the yield curve's new contour represents a sea change for the greenback.
The market reaction to the increasing certainty of the Fed's operation has been manifested by an acceleration in monetary disinflation over the second and third quarters. (See Chart 1.) Monetary inflation represents the level of depredation in the value of the U.S. dollar measured on a daily basis through the gold and forex markets. Higher inflation denotes a weakening in the dollar's global purchasing power while disinflation corresponds to a boost in the greenback's relative strength. Chart 1 depicts the completion of a double-top in the 365-day inflation rate formed in the second quarter, followed by a precipitous decline over the third quarter. This disinflation, in turn, produced a double bottom in real interest rates. (See Chart 2.) All this bodes for continuing strength in the dollar.
The most liquid marketplace for retail investors to pursue a strong dollar play is actually that of the “anti-dollar” — gold. And the most active expression of investor gold sentiment nowadays is the SPDR Gold Shares Trust (GLD), an exchange-traded fund backed by bullion.
Shorting GLD and buying GLD puts would be the natural choices for gold bears/dollar bulls, but each of these strategies is imbued with risks that could be distasteful. A short position in the ETF, for example, offers open-ended profit potential in a significant gold downtrend but also exposes investors to unlimited risk should bullion, instead, rise. There's only 2:1 leverage as well.
Buying puts, on the other hand, offers higher leverage and caps an investor's risk, but at a steep price. A put's premium reflects, among other factors, the volatility assumption of the seller. When you analyze an option premium, you can easily assess the influence of the contract's length and the price of the underlying asset as well as the impact of prevailing interest rates. The final — and most ethereal — factor is the seller's expectation of GLD's future volatility. Option sellers demand higher premiums as compensation for an anticipated increase. Option prices, on the other hand, tend to contract when the market for its underlying asset is projected to remain quiet.
Gold option traders' assumptions, measured by the CBOE Gold Volatility Index (see Chart 3), have been rising since July. In early summer, gold's fear index was near its historic low as bullion climbed toward an eventual peak above $1,900.
By late September, the gold VIX attempted to breach the 40 percent level, up from a July reading in the mid-teens. Many traders wondered if the index's lifetime high of 64.5 percent, reached in October 2008, could be surpassed. There's an implied bearishness in such a notion since the relationship between volatility and price is indirect: Volatility tends to increase on downtrends; it wanes in bull markets.
Traders betting on a volatility spike along with a decline in the price of gold, then, stand to lever their potential for gains in a sell-off. Buying puts offers a long volatility/short price stance, but can be very expensive, especially after a downdraft begins. The value of naked options, too, erodes when markets stagnate, making refractory periods costly for buyers.
The buy-in and decay problems can be overcome by using a spread — a combination of long and short put positions that allows investors to finance their put purchases with other people's money.
GLD Long Ratio Put Spread
In particular, a long ratio put spread can exploit the confluence of higher gold VIX readings and a serious breakdown in GLD's market price. The spread is built by shorting one or more put options and going long a greater number of puts with the same expiration but at a lower exercise, or strike, price. Seasoned option traders will recognize the position as the overlay of a long put on top of a bull put spread.
With GLD at $173.59 on 21 September, for example, a 3:2 ratio spread could have been constructed for a total net debit of $270.
The position is known as a long put ratio spread because more puts are bought than sold. Typically, these spreads are initiated at small debits or credits. In this case, the purchase price of the three $165 puts is almost entirely financed by the sale of the higher-struck contracts.
It's this financing that makes spread trading so attractive. As we'll soon see, the spread can produce substantial gains on a downside move in GLD's price while exposing the spreader to a clearly defined and strictly limited risk. In this way, the spread is very much like a long put. But the spread's cost is a lot less than that of an outright option. This spread costs only $2.70 a share, or $270 (remember, an option contract covers 100 GLD shares), versus a $580 debit for a $165 put.
Unlike an outright put purchase, the spread starts out essentially delta neutral, meaning the combined delta of the long puts is roughly equal to that of the short put leg. Delta denotes the sensitivity of an option position to changes in the price of the underlying asset. Long puts bestow negative delta, meaning the option is likely to increase in value as the price of GLD declines. Selling puts — a neutral-to-slightly-bullish strategy — yields positive delta. To achieve delta neutrality, the spread can be constructed in various ratios, i.e., 1:2, 2:3 or 3:5.
In this case, the long puts yield a total of 999 negative deltas (-0.999), largely offset by the positive 822 deltas imparted by the sale of the higher-struck options. Starting out slightly bearish at -0.177, the ratio spread should increase in value by 17.7 cents for every dollar GLD falls, at least on that one day. Delta's not constant. It will change, as we'll see, with the passage of time and in reaction to shifts in GLD's value.
Here's the kicker about the spread's delta neutrality: If GLD's price stalls, the spread's value won't erode as much as that of an outright put position. But on a strong decline, the spread's delta, influenced by the long put overweight, should become increasingly negative, making the spread behave more and more like a short GLD position.
Limited risk, open-ended profit
While the spread's profit potential is substantial, its risk is limited. You can easily see the loss potential by breaking the strategy into its two sub-positions.
Should GLD drop sharply, putting all the options deep in the money, the bull put spread will have a closeout value equal to the difference in its strike prices. If, for example, GLD drops below the lower strike price — $165 — the intrinsic value (the in-the-money amount) of the higher-struck option will always be $5 more than that of the lower-struck put. For a trader short a couple of spreads, that's two times $5 ($170 - $165), or $10. A negative ten-spot, mind you. A loss.
At the same time, the overlaid long put position will have a positive value equal to the difference between its lower strike and GLD's price. If GLD declines to, say $120, by the December option expiry, the $165 put should be worth $45.
Thus, with GLD at $120, the ratio spread ought to be valued at $3,500 ($45 per share times 100 shares for the long put, less the $10-per-share loss for the bullish component). Further declines in GLD would boost the intrinsic value of the naked put, while the loss on the bull put spread would be capped. That makes the ratio spread's potential for profit open-ended.
Open-ended, but not unlimited. Since GLD's value can't drop below zero, the strategy's potential value is limited to the lower exercise price ($165) less the spread between the strikes ($5 × 2 = $10), or $155 ($15,500).
Factoring in the initial $270 cost means the spread's maximum net profit is $15,230. That's a potential 56-fold return.
So much for the good news. What's the worst possible outcome?
Well, the maximum loss would be engendered if GLD settles at the lower strike price on expiration day. All three long puts, struck at $165, would be worthless, but the short $170 puts would be $5 in the money. The loss amounts to the in-the-money value — in this case, twice the difference between the put strikes — together with the debit paid when the position was initiated. Expiration day losses thus max out at $1,270, making the spread's reward-to-risk ratio 12:1.
This spread's intrinsic breakeven point is reached when GLD's price declines below the lower strike, inflating the excess put's value enough to overcome the loss on the bull put spread and recoup buy-in costs. That means the low-struck put must be in the money by $12.70 (equal to the $10 debit in the bull put spread plus the $2.70 initial premium outlay). That'll happen if GLD's at $152.30 when the options expire.
Note, however, that we're talking about intrinsic, or expiration, values here. The spread may — and, in fact, did — break even long before GLD dipped to the $152 level. On Sept. 30, with GLD settling at $158.06, the ratio spread had a close-out value of $560 — representing a 109 percent return.
The reason? A jump in the options' volatility assumptions. After little more than a week, the $165 call premium climbed to $13.50, implying an anticipated 32.4 percent volatility in GLD's price over the option's life. The spread's delta, too, downshifted to -.458, indicating increased sensitivity to a decline in GLD's price. A $1 drop then had the potential to bump up the spread's value by 45.8 cents.
The bottom line
Savvy traders are on the constant lookout for leverage together with controlled risk. A long ratio put spread in the GLD market offers an indirect but very liquid alternative to a long dollar position. By spreading, entry costs can be reduced and liquidation values better insulated during stalls or reversals.
Additional opportunities to spread GLD puts, like the positions illustrated above, may be offered on gold rebounds before year's end.