MoundReport.com's Trade
Of
The
Month
Gold Bear Put Ratio Breakout
Spread
James Mound
JMTG's Head Analyst
May 16, 2005
Trade description: Buy four August Gold 400 puts and
sell one August Gold 420 put for a credit of approx. $150. Margin
is approximately $650 but can fluctuate depending on time value
and market price. Options expire on 7/26/2005.
**Please see below for explanation
of ratio breakout spreads along with the pros and cons.
Explanation: Gold's recent breakdown off the several
month pennant formation suggests increased volatility is on its
way. Moreover, the market is at a critical price juncture, as
it appears ready for some serious downside, but is also testing
some technical support. This trade design provides for a highly
leveraged bear play that is exposed for loss in a flat or slightly
down market, but makes money in an up market and offers expansive
profit potential on a break below $393.80.
![](mound051605.jpg)
Daily Gold Chart Courtesy of Gecko Software's TracknTrade.
Profit Scenarios: Max profit is unlimited and occurs
at expiration as the market trades below 393.80. Profit is $300
per $1 move below 393.80 at expiration. Profit is $10 per .10
move above 418.50 to 420 (or above) which is max profit
to the upside at expiration ($150, or the credit received on
the trade). It is recommended to scale out of one of the 400
puts for $550 and a second scale out at $900 to remove a majority
of risk on the trade. Time value greatly increases profit potential
as the market nears $400.
Risk Scenarios: Max risk is $1,850 (assuming an entry
price of $150 credit) at expiration and occurs with the market
at exactly 400. Loss is reduced by $100 per $1 move above 400
to 418.50 which is breakeven at expiration. Loss is reduced by
$300 per $1 move below 400 at expiration down to 393.80 (breakeven).
Using proper exit strategy by not holding the full position to
expiration can greatly reduce the max risk. It is also recommended
that you cover the 420 put on a gold rally for less than $300.
This would create a reduced max risk of less than $150 and allow
for the remaining time value to work in the 400 puts favor.
Why use ratio breakout spreads?
Ratio breakout spreads offer
a unique opportunity to play a particular market definition.
As with all option spreading techniques, each approach allows
you to change your definition of market expectations from just
up or down directional logic to a more complex and potentially
probable scenario. The basic structure of a ratio breakout spread
is to sell an in, at or near the money option and use the premium
collected to buy multiple further out of the money options.
Using the recommendation above
as an example, the trade is designed to benefit from a low underlying
volatility in the market by buying out of the money puts, which
are relatively discounted due to the market's speculative perception
of downside potential in gold over the time frame of the trade,
as well as overall low volatility suggesting the market perceives
the potential for price spikes to the downside as unlikely. But
buying cheap out of the money puts falls under the category of
low probability option trading and one could easily argue that
the majority of option traders that fail are buying OTM options.
However, in this trade we sell a slightly in the money put to
collect premium, as at or near the money options in a less than
average volatility environment tend to hold a higher premium
than OTM options. Since there is a net credit on the trade this
allows the market to rally and achieve the credit received, or
sell off dramatically to benefit from the leveraged ratio of
puts (4 to 1 or a net of 3). Overall this trade design avoids
paying over $500 for the long puts and wins in any market scenario
that does not put gold between 393.80 and 418.50 come July 26th.
Also, because the time value depreciation curve is quite sideways
for the first 6 or 7 weeks of the trade, the play avoids the
time value decay pitfall found in buying OTM options. If you
compare the approach to being a straight buyer of 400 puts, you
would find the following benefits and drawbacks:
Benefits:
- Stretched time value decay
- More exit strategy choices
you can buy back the 420 put as described in the trade
rec to essentially reposition the trade at a better price, scale
out of the long puts at different price points, and even scale
out of 3 puts to create a credit put spread to play the possible
chop back up
- Sells better premium collection
and buys premium at a discount
- Moves risk from cost of trade
to a particular market scenario
- Plays against a slight downtrend
over time as opposed to straight put buying which plays against
any move other than a strong selloff
Drawbacks:
- Not necessarily profitable
on a slight down move
- Exposed to larger total risk
as time progresses than straight puts
- Lower breakeven point at expiration
- Margin can exceed the amount
that would be required to just hold long 400 puts
May 16, 2005
James Mound
JMTG's Head
Analyst
email: info@Moundreport.com
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Contact a customer service representative
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for more information.
Charts Courtesy
of Gecko Software's TracknTrade
Disclaimer: There is risk of loss
in all commodities trading. Please consult a James Mound Trading
Group Broker before you trade for the first time. Losses can exceed
your account size and/or margin requirements. Commodities trading
can be extremely risky and is not for everyone. Some option strategies
have unlimited risk. Educate yourself on the risks and rewards
of such investing prior to trading. James Mound Trading Group,
or anyone associated with JMTG or moundreport.com, do not guarantee
profits or pre-determined loss points, and are not held monetarily
responsible for the trading losses of others (clients or otherwise).
Past results are by no means indicative of potential future returns.
Information provided are compiled by sources believed to be reliable.
JMTG or its principals assume no responsibility for any errors
or omissions as the information may not be complete or events
may have been cancelled or rescheduled. Any copy, reprint, broadcast
or distribution of this report of any kind is prohibited without
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