No one likes to waste time so I will give it to you straight. If you have no interest whatsoever in trading options and/or if either this, this or this cause your eyes to glaze over, I’m going to suggest that you stop reading right here.
But thank you for checking in and have a nice day.
Alright, now that they’re gone…..one of the things I like to (try) to do is to go beyond teaching people “about trading” (“this is what a risk curve for a butterfly spread looks like”) and get more into “how to trade” (“this looks like a good time to use/adjust a butterfly spread because…”).
In the articles linked above I wrote about a hypothetical bearish on gold trade using put options in GLD. That trade will expire at the close on 6/20. Before that happens I am going to add one more update.
The Current State of Gold Affairs
In Figure 1 you see the risk curves for the original (adjusted) trade.
Figure 1 – Risk curves for Out-of-the-money GLD put butterfly spread (Courtesy: www.OptionsAnalysis.com)
The good news is that:
a) The trade cannot lose money
b) There is still additional upside potential if GLD declines towards 119 between now and the close on 6/20.
The bad news is that most of the open profit can still vanish if GLD advances towards 125 between now and the close on 6/20.
So several choices available to a trader are:
a) Hold on if you think GLD will move sideways to lower in the next 48 hours
b) Exit the position if you think GLD will move higher in the next 48 hours
c) Adjust the current position
No surprise, I choose “C”. Here’s why:
1) First off I don’t have a clue what GLD will do in the next 48 hours. I do know that after holding this trade since March 6, I don’t want to end up with a meager profit (which would be the case if GLD rallies above 125. But I don’t necessarily want to exit because there is still a lot of additional profit potential available of GLD does happen to sell off in the next 48 hours.
2) Additionally I think you can make a bullish case for GLD going forward. As you can see in Figures 2 and 3, the Elliott Wave count on both the daily and weekly charts show a completed 5 wave down pattern (to all of you “non Elliott Heads” this implies that downside momentum is waning and that a new up move may begin). Now I am not a true Elliott believer but I do pay attention when both the daily and weekly counts point in the same direction. 
Figure 2 – Daily GLD with completed Elliot Wave 5 (Courtesy: ProfitSource by HUBB)
Figure 3 – Weekly GLD with possible completed Elliot Wave 5 (Courtesy: ProfitSource by HUBB)
So let’s survey the situation:
1) I have an open position with an open profit that could get bigger or smaller in the next 48 hours and I have no opinion which way it might go during that time.
2) I have an open profit of $544 “burning a hole in my pocket”.
3) I have some reason to believe that GLD may advance in price moving forward.
What to do, what to do?
Well, in reality the choices are limitless. But here’s what I’ve come up with:
*Continue to hold the trade but also spend some of the open profit to position myself for a potential up move in gold. How to accomplish this? Relatively simple: Buy 1 March 2015 GLD 130 call option for $3.10, or $310. The risk curves for this newly adjusted trade appear in Figure 4.
Figure 4 – OTM Put Butterfly PLUS long March 2015 130 call option (Courtesy: www.OptionsAnalysis.com)
A few things to note:
1) If GLD somehow happens to fall below 119 between now and June expiration, the put portion should be exited as this trade would start to lose profit and could even turn into a loss if GLD plummeted.
2) On the upside, the smallest profit we would have at June expiration is $100. But even in that worst case we still hold a “free” March 2015 130 call option.
The risk curves for this position after June expiration appears in Figure 5. In essence we made $234 on the put butterfly and were able to buy a free long-term call option.
Figure 5 – Risk curve for Long GLD 2015 130 call option (after June expiration) (Courtesy: www.OptionsAnalysis.com)
Summary
Is this option trading stuff fun or what? A couple things to note. First, figuring out which trade to put on initially is only one part of the equation. Other considerations are:
*When to exit with a loss?
*When to exit with a profit?
*Can the trade be adjusted to increase potential and/or reduce or eliminate risk of loss?
The trade and adjustments covered in this series of articles serve merely as an example of “how to trade” options. Another trader may well have come up with a different (and yes, possibly better) initial trade, and an entirely different series of adjustments (or no adjustments at all).
The key thing to take away is the potential to use options to create positions that offer opportunities not available to traders who focus only on individual stocks, indexes and ETFs.
Jay Kaeppel
