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Using Options To Hedge Risk In Your NUGT And DUST Trading

Robert Edwards has written a number of Instablogs relative to trading the Gold Miners NUGT and DUST 3X ETF funds, most recently one discussing trading strategy leveraging both NUGT and DUST in order to hedge risk of price movement against traders, as well as to create opportunity to profit from price swings, article here.

This article is intended to provide another option for the risk hedging strategy using options in NUGT and DUST that fit right into the strategy associated with tranches Robert created, as well as to provide some basic considerations associated with using options to offset risk in a position. It is not intended to provide a complete advanced discussion on Options trading and traders should certainly leverage other sources to gain a thorough understanding of Options Volatility, Pricing and Characteristics.

Lets first assume that a trader through fundamental and technical analysis has determined they are bullish on the Gold Minders ETF NUGT. Following the approach Robert developed, a trader would accumulate into a position with 1/3 of funds allocated for trading associated with the Gold Miners. Further, lets assume the trader has entered these positions and the price movement begins to work against NUGT (which would be positive for DUST - the inverse of NUGT).

Working Example to Demonstrate:

The theoretical trader has accumulated shares in NUGT at an average price of $30, and has fully invested the first tranche representing 1/3 of funds to allocate to trading Gold Miners. We will ignore the impact of commissions in this example.

Total Funds allocated to trading Gold Miner ETFs: $36,000

1st Tranche: 400 NUGT purchased @ 30 = $12,000. If the NUGT price moves against the trader to $27, the trader may become concerned about the downside risk (as well as eager to find a way to participate in the opportunity this risk creates). NOTE: Assumption is that regardless of near-term downside risk, the trader is still convinced we are headed in a bullish direction on the underlying NUGT position in time.

Robert's approach suggested using the 2nd tranche of funds at this point to buy offsetting DUST positions. So, this approach would roughly use the next $12,000 in funds.

Alternative Options Approach:

We will assume that a trader has a reasonable level of understanding of Options Volatility, Pricing and Characteristics, has access to analysis tools from their broker (Fidelity has a good suite of strategy and analysis tools for Stock/ETF options traders), and can perform analysis associated with the Greeks. Investopedia has some good discussion on the web of the Greeks, which can be found at the link here.

We will use an example that leverages NUGT put options to hedge the downside risk and capitalize on the opportunity. But, a call option on DUST should have very identical characteristics to a NUGT put option.

It is 1/3/2014 today and my belief if that the position has downside risk during the next 4 weeks, but I am confident that within that time frame, we will ascend bullishly with NUGT. In order to provide ample coverage time opportunity, I have decided I would like to provide coverage for this downside risk to the February 22nd option expiration date. NOTE: If I decide later I want to extend that timeframe, I can always Roll Forward the option to a later expiration date.

Pulling up the Option Chain for NUGT puts expiring 2/22/14, I find that: 2/22/14 NUGT puts at 27 strike are priced at $3, and the 25 strikes are priced at $2.20. Further, I decide that I want to hedge all my downside risk from here (as well as participate in all downside profits from movement dollar for dollar). So, I buy 4 put option contracts (representing 400 NUGT shares) that at expiration would $1 for $1 to the downside, exactly offset my losses on NUGT from 27 on.

My complete position would now look like this:

Tranche 1 - 400 NUGT purchased at $30 = $12,000. (Now trading at 27, this is at a loss of $1,200).

Tranche 2 - 4 2/22/14 $27 Strike put options purchased at $3, or $1,200.

To demonstrate the power of this approach, lets assume that in the next 2 weeks, the price of NUGT goes to $20 and I am convinced this is the bottom and price momentum is turning upward. My NUGT position would now be at a loss of $4,000, but my put options would likely be priced at roughly $10, or a total of $4,000. Options have time decay which might decrease the value slightly in this time frame, but if volatility increased in the down move, the option may be worth even more than the offset in the NUGT loss.

Tranche 1 - 400 NUGT purchased at $30, now at $20 on a total loss of $4,000. The $1,200 from before we purchased the option + the $2,800 losses down from 27 to 20. ($4,000)

Tranche 2 - Investing only $1,200, to purchase offsetting put options, we are now on a gain of $7 X 4 contracts X 100 shares, or $2,800 profit (completely offsetting the $2,800 loss on Tranche 1 after we bought the put (less any amount of decay to the $1,200, or any +/ - for changes in implied volatility associated with the options.

We can now sell the put option capturing the profit opportunity from the move in price against the Tranche 1 position. And, now we are still holding NUGT and can ride the position up to our price target for a profitable trade on that position.

Advantages of using protective put versus buying DUST in Tranche 2:

1) Offsetting our losses and creating the profit opportunity required only $1,200, rather than the full $12,000, providing us with greater portfolio leverage for investable capital.

2) If the price movement immediately turned up from the $27 price point, in DUST we would be losing unlimited funds as NUGT climbed. With the puts, our maximum loss would be $1,200, but we could also stop those losses by selling the put at a small loss when the price movement changed - and if we believe the downside risk has expired.

3) Flexibility - We can always roll forward a put or purchase another put. And, we have options on different strike prices for different levels of protection. Further, we can adjust for different decisions on option strike prices, cost of purchase, ratio of downside protection and more, using less funds from Tranche 2.

In Summary, I believe protective puts are a tremendous tool to the NUGT/DUST trader in hedging the risk of price movements against your position, while providing greater portfolio leverage. With this statement however, there is an assumption that the trader does have a reasonable understanding of options volatility, pricing, and the greeks.

Happy, prosperous trading in 2014!

Disclosure: I am long NUGT, NEM.

Additional disclosure: I may trade in and out of NUGT, DUST and NEM in the near future, as well as initiate call or put options in NUGT, DUST or NEM.

Stocks: NUGT, DUST