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On 3/7/14, I wrote a piece called “There’s Garbage in That Thar Gold”.  That article highlighted a hypothetical trade using put options on ticker GLD.  The position was basically a low cost hedge against a decline in the price of gold that used a strategy known as “The Garbage Trade” which I learned from Gustavo Guzman, a former colleague of mine at Optionetics.

(Most recent article: JayOnTheMarkets.com: A Warning Sign to Watch http://tinyurl.com/mxr7jg7)

Well some “stuff” have happened since then.  Ticker GLD has declined from 130.16 a share to 124.17.  So had a trader assumed the risk of selling short 100 shares of ticker GLD he or she would presently be holding a trade with an open profit of 4.6% in 62 days.  Not bad, but consider the alternative.  The original Garbage Trade involved:

Buying 4 Jun 125 puts

Selling 8 Jun 119 puts

Buying 4 Jun 113 puts

The total cost to enter this trade – and the maximum, worst case loss – was $272.

As of the close on 5/7/14 this trade is showing an open profit of $304, or +111.8%, as shown in Figure 1. 

Figure 1 – Updated GLD “Garbage Trade” (Courtesy: www.OptionsAnalysis.com)

So consider the following choices:

*Put up margin and assume unlimited risk to sell short 100 shares – return to date: +4.6%

*Put of $272 as your total risk to enter the garbage trade – return to date: +111.8%

This is a simple but powerful example of the potential leverage power – and risk limiting capabilities – of using options.

Adjusting the Trade

As you can see in Figure 1 this option trade still has a great deal of additional profit potential if gold continues to decline.  But it also still has the potential to end up as a losing trade.  So for arguments sake, let’s say you were pretty happy with 111.8% and didn’t want to take a chance of giving it all backing and/or possibly still end up losing money – which could happen if GLD rallies (or declines) far enough between now and June option expiration.  Options give you a lot of flexibility in terms of trade adjustments.  Let’s consider the following potential theoretical adjustment:

*Let’s simply close out half of the option position

This leaves us with the position that appears in Figure 2.  Note that the maximum profit potential is reduced significantly.  However – and more importantly, this adjusted trade has a locked in profit (before commissions).Figure 2 – Adjusted Garbage Trade that eliminates risk of loss  (Courtesy: www.OptionsAnalysis.com)

So a trader who put on the original position risking $272 and made the adjustment above, now has an open profit of $304 and no more risk of loss.

Summary

So is this the great trade of all time?  Hardly.  But the point is not really to hype the trade but simply to point out the potential for entering low cost trades using options that can take advantage of “possibilities” as well as the potential to adjust such trades to lock in a profit.

Jay Kaeppel