Gold is extremely oversold on a short-term basis, as seen by every measure. So it’s time to try out a GLD options trade.
The commodity has taken a dive over the past week and looks like it might be hitting some decent support. When this type of set-up occurs, particularly during high implied volatility environments, I like to place a “mean-reversion” trade using a risk-defined credit spread, like a bear call, bull put, or iron condor.
In this instance, since SPDR Gold ETF (GLD) is in an extremely oversold state, I would look towards a bull put spread to fade the current directional trend.
As always, the first step in placing a bull put spread, or any trade, is making sure the stock we are interested in has highly liquid options. We want to use the most efficient products possible.
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SPDR Gold ETF (GLD) – Bull Put Spread Example
GLD offers a highly liquid options product, so it’s always on my watch list.
And again, with GLD trading for 164.72 and at near-term lows, I want to place a bull put spread with a high probability of success.
Let’s take a look at the August options chain for GLD with 45 days until expiration. Once we have an expiration cycle that we are comfortable with we can then proceed with locating the put strike with approximately an 80% probability OTM (out-of-the-money), otherwise known as the probability of success on the trade.
It looks like the 154 put strike with an 81.24% probability of success is where I want to start. The short put strike defines my probability of success on the trade. It also helps to define my overall premium or return on the trade.
Once my short put strike is chosen, in this case the 154 put I then proceed to look at the other half of a 3-strike wide, 4-strike wide and 5-strike wide bull put spread to buy.
The spread width of our bull put helps to define our risk on the trade. It also tells us how much capital is required for each bull put spread. The smaller the width of the spread the less capital required. When defining your position size, a key element of risk management, knowing the overall risk or capital required per trade is essential.
For our bullish put spread example, let’s take a look at the 5-strike wide spread of 154/149.
The GLD Options Trade: GLD 154/149 Bull Put Spread
Simultaneously:
Sell to open GLD August 19, 2022 154 put strike
Buy to open GLD August 19, 2022 149 strike for a total net credit of roughly $0.50 or $50 per bull put spread
- Max Return: 11.1%
- Probability of Success: 81.24%
- Total net credit: $0.50, or $50 per bull put spread
- Total risk per spread: $4.50, or $450 per bull put spread
As long as GLD stays above our 154 strike at expiration in 45 days, I have the potential to make 11.1% on the trade.
In most cases, I will make slightly less, as the prudent move (and all research backs this up) is to buy back the bull put spread prior to expiration. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.50, I want to buy it back when the price of my spread hits roughly $0.25 to $0.10.
Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to lead the way for our decisions. But, taking off risk by locking in profits is never a bad decision and by doing so, we have the ability to take advantage of other opportunities the market has to offer.
Risk Management
Since we know how much we stand to make and lose prior to order entry we have the ability to precisely define our position size on every trade we place.
Position size is the most important factor when managing risk, so by keeping each trade at a reasonable level (I use 1% to 5% per trade) it allows not only the Law of Large Numbers to work in your favor … it also allows you to sleep well at night.
Moreover, I like to take off the trade if the cost to buy back reaches 2x to 3x my original credit ($0.50). So, in this case, I would look to take off the trade if it hit $1.00 to $1.50.
I hope this bull put spread example helps give everyone a little insight into how a bull put spread works. I will be following this up soon with a short video going through numerous bullish put spread examples. Stay tuned!
As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below. And don’t forget to sign up for my Free Newsletter for education, research and trade ideas.
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