Saturday, February 14, 2009

All That Glitters is GLD

GLD has continued it's bullish run and received a strategy recommendation on last night's Options Action. Concerned with the run that the GLD has already had, as well as it being potentially overcrowded, the recommendation for those buying stock was to provide some protection by selling some upside calls and buying some downside puts. In other words, a collar trade. I gotta admit, I'm not a big collar trader and think there are usually better alternatives in the options world.

Let's take a look at an example:

Buy 100 shares GLD @ $92.50
Sell March 98 call for $2.30
Buy March 88 put for $2.00
Net Debit = $92.20
Max Risk = $4.20 (if stock below $88)
Max Reward = $5.80 (if stock above $98)
ROI= $4.20 / $92.20 = 4.5% return
The Risk-Reward ratio is over 1:1. I'm risking $420 to make $580, which sounds pretty good. However, because we're buying stock the net debit is $92.20. So I'm tying up a ton of capital on a trade which in the end is merely risking $420 to make $580. This begs the question, is there a cheaper way to build a position that risks $420 to make $580? The anwer is yes.

Collars are synthetic bull spreads. In other words, the risk-reward characteristics of collars can be the exact same as a bull call or bull put spread. The main difference is the bull spreads are a heck of a lot cheaper. My last post on GLD highlighted a bull call spread- if you haven't seen it, take a look here.
Here's an alternative bull call spread:
Buy March 88 call for $6.65
Sell March 98 call for $2.30
Net Debit = $4.35
Max Risk = $4.35 (if stock is below $88)
Max Reward= $5.65 (if stock is above $98)
ROI= $5.65 / $4.35 = 129% return

Are you able to differentiate between the two risk graphs? No? That's because there really isn't one! I'd much rather tie up $435 than $9220. Now, I assume if you already own stock and want to protect, then collars may be the way to go. However, if I'm constructing a new bullish trade I'd take the bull call spread over the collar any day of the week.

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