Growfast's  Instablog

Send Message
Stock, Options, ETF and Commodities Investor; My educational background is in Computer Science and Accounting with significant entrepreneurial and Fortune 100 Corporate experience in Information Management and Technology services in industries including: Consulting, Oil and Gas, Manufacturing,... More
  • Using Options To Hedge Risk In Your NUGT And DUST Trading 10 comments
    Jan 3, 2014 6:29 PM | about stocks: NUGT, DUST

    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
Back To Growfast's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (10)
Track new comments
  • glaserdx
    , contributor
    Comments (274) | Send Message
    This is great!
    Next helpful move would be if you could alert us in real time - similar to R.E. - when you implement this put strategy so we can follow you.
    That would be tremendous. Thank you!
    3 Jan 2014, 09:32 PM Reply Like
  • Robert Edwards
    , contributor
    Comments (587) | Send Message
    Yes Grow, thanks much for your thoughtful and thorough analysis and I agree with you that put options have many advantages over buying DUST as a counterweight. It is great to keep the cash outlay down. Also, buying insurance on a hard down move is imperative, and still allows for participation on an eventual up move. My only suggestion might be to possibly consider selling an out of the money call, several months out possibly to help pay for the put insurance.


    On a very short-term basis (like while day trading), I still see the benefit in trading DUST and NUGT in some teeter totter fashion. However, if one stays in the position for say one week, or if movement goes against your original position say 10%, as in your example, then it is imperative to take downside protection as you describe. One would have to experiment to determine the optimum time to buy a put. Is a 10% loss the optimum time to put on the put, or is 15%. Or should the put be purchased at the start? There is much to consider when setting up guidelines as to how and when to implement the strategy you describe as well as mine.


    The great thing about corroboration is that no one person has all the best ideas or information, but in a group, the power of the many can far exceed the power of the few. One can break a single stick easily, but when placed in a bundle, it is quite strong. Thanks for your put advice as it will save me and many a trader from being broken by a hard down turn in NUGT which might occur in the future.
    4 Jan 2014, 06:48 AM Reply Like
  • Growfast
    , contributor
    Comments (295) | Send Message
    Author’s reply » Glaser,


    I certainly will do this going forward. Also, when I feel strongly about a short-term trend on my bullish call as I did this past week, I may periodically purchase call options on NUGT to enhance performance of NUGT holdings. But, will communicate it in real-time.
    4 Jan 2014, 09:54 AM Reply Like
  • Growfast
    , contributor
    Comments (295) | Send Message
    Author’s reply » Robert,


    You touch on lots of good points. I thought about incorporating much of this in the article but was afraid it would be too much information for 1 post. Some highlights:


    1) Day Trading or weekly trading to play the teeter totter Lefty6X6 talks about, is often times probably advantageous to use NUGT and DUST. Options may have a place, but the analysis has to ensure option pricing is low. Volatility on 3X ETF's like NUGT and DUST can make the options pricey at times. Also, traders can be affected by whether they trade from a cash or margin account as to frequency of trades and cash coverage to cover carry of settling ETF positions versus 1 day settlement on options.
    2) Most often, I look for opportunity to trade on an intermediate term. Options hedging works well for this type of trade as during the intermediate term, there may often be several down moves to profit from, or the occasional bad news that can drive down a position with losses. Along with the intermediate position and the put insurance, I also have begun to try to take advantage of shorter-term moves with shorter-term supplemental trades. This can be selling out of the money calls you mention (why I like to own the underlying on intermediate trends), buying calls to enhance performance on a good move and using trading shares of NUGT and DUST for short-term trades as well. This gets into potential to break tranches into intermediate term funds and short-term funds.
    3) Long term pricing on NUGT and DUST options because of the nature of high volatility, are always expensive and so far, I have been reluctant to purchase these long-term (say 6 months or more) unless I felt very strong there would be large moves in Gold or miners.


    Regarding your comments on corroboration, I completely agree. On your forums, many of us have learned a tremendous amount and shared strategies that I provide traders with tools for all markets and conditions. Thank you for all your input along the way.
    4 Jan 2014, 10:07 AM Reply Like
  • Growfast
    , contributor
    Comments (295) | Send Message
    Author’s reply » In the last paragraph, I meant to say that "I think provide traders..."
    4 Jan 2014, 10:16 AM Reply Like
  • rodh7858
    , contributor
    Comments (133) | Send Message
    Thanks for a thorough article Grow.
    Since $NUGT/$DUST options are not as liquid as $GDX options, the bid-ask on the former options are quite high thus increasing the hedging cost. What are your thoughts on buying options on $GDX as a hedge on your NUGT/$DUST positions?
    4 Jan 2014, 09:43 AM Reply Like
  • Growfast
    , contributor
    Comments (295) | Send Message
    Author’s reply » Rod,


    This is a great idea I want to look into and study further. Of course, this would require the purchase of more contracts to fully cover the delta against the NUGT or DUST 3X leverage, but that is easy to work on the ratio.


    The next thing I would want to look at is the correlation between GDX and NUGT to see that they move together. I have not studied the underlying holdings of GDX to know whether to expect very tight correlation. But in general, with higher liquidity, this could very well be the way to go. Will dig into this a bit and share with the group.
    4 Jan 2014, 10:10 AM Reply Like
  • glaserdx
    , contributor
    Comments (274) | Send Message
    Rob, Grow, Rodh
    I have learned much from you and utilize your experience, ideas, and comments to springboard my learning curve. This collaboration is education at its best. Thank you.
    4 Jan 2014, 11:50 AM Reply Like
  • glaserdx
    , contributor
    Comments (274) | Send Message
    Neglected to also thank Lefty6x6 and others in previous comment
    4 Jan 2014, 12:00 PM Reply Like
  • shopvac20
    , contributor
    Comments (14) | Send Message
    Grow, thank you for taking the time to write this article, it is a great approach. I plan to do some mock option trades ( I just write down, date, time, trade amount and value ) - and track myself, earnings and losses. This way I can get a full understanding risk free :). I am sure I will have more questions along the way.


    I think RE, Grow, and everyone else who is a contributing "member" to our little community. We all seem to be committed to learning and making money :)


    as Glas said, Collaboration is education at its best !!!
    5 Jan 2014, 12:58 PM Reply Like
Full index of posts »
Latest Followers


More »

Latest Comments

Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.