Grappling With GLD’s Softness With Options

This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options. Almost 128 million options on ETFs were traded in June, and because ETFs and options are among the fastest-growing financial vehicles in the world, it only makes sense to combine the two. This column highlights unusually large or interesting ETF options trades to help readers understand where traders believe a particular ETF may be headed. In doing so, Nations examines the underlying options strategy.

With all the turmoil in Greece, it’s easy to understand why traders might want to own gold. Gold is supposed to be a refuge during such turmoil, as investors look for a hard asset when “soft” assets are in trouble.

One institutional options trader is doing just that, but he realizes that gold didn’t rally very much on Monday when the stock market was having its worst day of the year. So he’s using options to establish a fascinating position that’s similar to ownership of gold, but it won’t get hurt if gold is down slightly, and that cost him just $0.04.

The SPDR Gold Shares (GLD | A-100), the world’s biggest gold ETF, has had a pretty disappointing year, as the end of quantitative easing and the outlook for higher interest rates have tempered interest in owning an asset that pays no dividends but requires paying for storage and insurance.

GLD is down 12.2 percent over the past 52 weeks, as you can see:

Taking Measure Of Gold’s Slide

The 52-week performance has been disappointing for gold bulls, but what is probably even more troubling for traders is GLD’s performance on June 29, when the wave of bad news from Greece crested.

The S&P lost more than 2 percent and bond prices shot higher. But gold moved relatively little; GLD rallied only 0.45 percent. In gold’s “good old days,” this sort of turmoil would have fueled a gold rally of several percent.

So gold isn’t reacting to geopolitical trouble in a way that would make someone long-GLD very brave. But if you still think GLD has a chance to rally—maybe if the situation in Greece spreads to Italy or Spain—but don’t want to lose money if its moderately weak performance continues, what is to be done?

One Way Out

One institutional trader answered that question on Tuesday. He began by buying call options on GLD. Specifically he bought 3,750 of the $116 strike calls expiring in August and paid $0.91 for them. Because each option corresponds to 100 shares, he paid a total of $341,250 for these calls. That sum would be his maximum loss.

In being long-calls, he now has upside exposure to GLD. But if GLD doesn’t rally, he’s going to lose his entire options premium. To reduce the cost of the entire trade, he also sold 3,750 of the $108 strike puts expiring in August and received $0.87 for them. Shorting these puts adds more bullish exposure and reduces the cost of the entire trade to just $0.04 per share, or a total of just $15,000, a 96 percent discount.

This trade structure, long an out-of-the-money call and short the out-of-the-money put to pay for it, is called a risk reversal. It’s very similar to a long position in GLD with two important differences.

First, it’s drastically cheaper than just paying $112.37 for GLD, which is where it was trading when this risk reversal was executed. Second, there’s a big range of prices for GLD at options expiration, where the loss for this risk reversal is just the $0.04 net paid even if GLD has fallen.

Looking At Payoffs

You can see the payoff profile for this risk reversal along with the payoff profile for simply buying GLD at $112.37:

With GLD between $108.00 and $116.00 at option expiration, the loss is just $0.04, which would be pretty disappointing if GLD had rallied to, say, $115.90. But the loss would be the same $0.04 if GLD had fallen to $108.10, which would make our trader feel much better about getting long exposure to gold despite the fact that it didn’t seem to want to rally.

Limited Downside

As such, any risk reversal is like saying: “I’m willing to get long but only if there is a big move in either direction. I’m willing to pay $108 if GLD drops substantially because I’ll be buying at a discount, and selling that put drastically reduces the cost of buying those calls. And buying those calls allows me to get long at $116 if there’s a big move higher, as I’d expect if the situation in the eurozone really deteriorates.”

If there’s not a big move, then the options expire and there’s no harm done.

Risk reversals are an elegant way to get unique exposure to GLD at very little expense, the sort of low-cost exposure that is only possible using options.

At the time of writing, the author didn’t own a position in GLD. Follow Scott on Twitter @ScottNations