Thursday, April 29, 2010

Time to Shine?

With Tuesday's free fall in equities came a rush into the supposed safety zone of gold. After lying dormant for five months, gold is knocking on the door of a potential breakout. Since December 2009, gold has found a home within the $100 point range between 1060 and 1160. Will this base serve as a launching pad for a breakout and resumption of its longer term uptrend? To further support this premise, those with a knack for chart reading may also be noticing the multi-month inverse head and shoulders pattern that is on the cusp of completion.

[Source: MachTrader]

How about considering selling a put spread on the SPDR Gold Shares (GLD) to take advantage of a continued rise in gold? With a mere three weeks remaining in the May expiration cycle there isn't much extrinsic value remaining. As such, I'd probably opt to use June options in constructing the put spread. Suppose we sell the June 110 put for $1.40 and buy the June 105 put for $.50. As long as GLD remains above $110 by June expiration, we're looking at a maximum reward of $90.

As is the nature of all OTM put spread, we have a relatively high probability of profit but a smaller risk/reward ratio. That said, a $90 return on $410 is still over a 20% return.

For related posts, readers can check out:
Previous GLD Posts
Bull Put Spreads


Anonymous said...

Hi Tyler,

Reading your post I've found the trade's high probability of profit could make it attractive, but at the other side the risk/reward doesn't sound accordingly. So I've thought of using the mathematical expectation formula what it looks like.

I've used this formula:
prob(profit)* max profit + prob(loss)* max loss

73% * 0.9 + 27% * 4.1 = -45,45 %

If I'm right with my calculations, it wouldn't be a fair bet.

What do you think about it? Could I be using this formula ? Have I missed something?

I'm expecting your comments.

Lluis (Siull)

Tyler Craig said...

Hey Lluis,

Good observations. Based on the nature of OTM put spreads, the risk/reward actually does sound correct in this instance. A higher probability of profit will ALWAYS bring higher risk and lower reward. If it didn't, you'd be hard pressed to find someone to take the other side of the trade.

If I recall correctly the expected value for virtually every spread I've looked at is negative. That's the nature of the beast. Since they're usually negative, I don't find much benefit in using expected return in my evaluation process. It doesn't really tell me anything I don't already know.

Another strong reason I don't use expectancy is b/c it assumes the stock has equal probabilities of rising or falling. Based on my chart reading, I assume GLD has a much better chance of going up in value. As such I feel I have an edge going bullish despite whatever the expected value may be.