When Gold Ratios Go Bad

Tyler Craig: I received the following question from SJ in response to last week’s Gaming Gold with Ratios post:

Curious to know how you would handle a “stop loss” situation in above mentioned trade. The upper breakeven point 3-4 wks out from expiration is quite a bit lower than that at expo – if the SPDR Gold ETF (NYSE:GLD) continues to grind higher and it has passed current breakeven but is below expo breakeven. You could hit max gain of the spread at expo but carry gamma risk(?) on the OTM calls in the days leading up to expo – wondering if you could share your approach to handling a situation like this.

The trade mentioned was a May call ratio spread consisting of one long May 150 call and two short May 152 calls.  The entire position was entered for a $1.05 net credit.  The trade is structured to profit in three scenarios:  a drop in price, sideways movement, or a slow drift higher.  Since the position involves short naked calls, there is risk if GLD rises too quickly- hence SJ’s question.

Here are three suggestions for how to manage the ratio spread if GLD rises too quickly- listed from simplest to most complex:

1.  Set a pre-determined exit point to close the position altogether.  Identifying the exit point comes down to personal preference.  The simplest is to probably use the dollar amount of the loss.  If you’re willing to risk $300 in the trade then bail once you hit $300.  If you only entered one spread then you may be able to give the trade a long leash. If you entered with a lot of contracts, then you will have to bail much quicker.

You may also consider using the delta of the position.  It starts off close to delta neutral but acquires negative delta at an increasing rate as the stock lifts.  If you reach a point where the delta is too high leaving you uncomfortable with the amount of directional exposure, close the trade.

2. Instead of closing the trade, some opt to make an adjustment.  Two adjustments you may consider are closing part of the position or rolling the short calls further OTM.  As far as the first one goes, if you entered two 1×2 ratio spreads then close one of them.  You immediately cut your remaining exposure in half.  An example of rolling further OTM would be closing the short May 152 calls and selling the May 153, 154 or some other higher strike price.  This also reduces your delta exposure, but leaves you open to additional upside risk if the bull run remains in force.

Keep in mind the original trade idea was based on the premise of wanting to play some type of short term top in GLD.  Those of the opinion commodities are a one-way freight train shouldn’t be entertaining thoughts of top calling anyways.  My main point was that I usually prefer the call ratio spread over shorting stock, buying puts, or selling vertical call spreads when playing an overextended name.

Written By Tyler Craig From Tyler’s Trading

ABOUT: Tyler Craig, author of Tyler’s Trading and owner of TC  Trading, Inc. Over the years I’ve educated hundreds of traders through my work with one of the nation’s leading educational firms. I enjoy writing and am a current monthly contributor to the Wealth Intelligence Magazine.  My writings have also been featured in Expiring Monthly and frequently show up in the Abnormal Returns Options Newsletter.  In 2009 I started Tyler’s Trading to share daily market commentary on stocks and options.

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