2 Options Strategies For Profits From A Hated Sector

mining stocksIn response to a recent article I wrote on the Gold Trust ETF (GLD) some readers have asked my thoughts on gold miners. While my last article was more of a bullish thesis on gold from a fundamental perspective and offered a simple strategy of playing gold by buying GLD, this article on the Market Vectors Gold Miners ETF (GDX) will offer a more complicated strategy. The reason for this has to do with the leverage of GDX:

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During this gold bear market, GDX has significantly underperformed GLD, making the miner ETF a riskier buy-and-hold. Yet when gold spikes, GDX spikes more quickly:

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GDX is more responsive to changes in the price of gold, making it more apt for a high risk, high reward options strategy. Why options? Because the initial investment is considerably cheaper than outright buying the ETF.

That said, if you want a safer strategy and are willing to put down considerable amounts of cash, just go with buying GLD. For those of us who believe that gold will rally and wish to maximize our profits, options on GDX make for a superior strategy. In the following strategy on GDX, I will outline an options play that is both 33% cheaper than the outright purchase of calls and immune to time decay.

A Reverse Collar Play on GDX

First, note that this play is only for a speculative position on GDX. The play includes the selling of puts, which can expose you to considerable risk. However, if we know the risk beforehand, we can think of the max risk as the initial investment and the price paid as the “down payment” for the position.

The example reverse collar below, for instance, has a “price” of $1,757.90 with a “down payment” of $108. Only if GDX drops significantly will you have to pay even a portion of the price; thus, the risk is actually smaller than it seems. Still, this mindset can help you limit losses.

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Why and when would you open the options strategy above? This strategy is best for when you believe a stock or ETF will rally quickly. The rally need not be sustained for this strategy to pay off; instead, you can take your profit after the rally and then reopen the strategy continually on each dip in a longer bullish position.

Note that the price of the call options, if bought flat out, would be $150 each. By selling the puts at roughly $50, we have reduced the cost of this strategy by 33%. In addition, the selling of the puts increases our delta, which is the amount of dollars you stand to gain for each $1 increase in the price of GDX.

The third advantage of selling the puts along with buying the calls is a reduced theta value. Had you not sold the puts, theta would be significantly larger in magnitude, leading to significant daily losses if GDX trends sideways. Instead, our theta is near zero, which implies virtually no time cost for keeping this strategy open while you wait for the rally.

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Risk: Looks Bad on Paper, But Reality Disagrees…

This is a highly aggressive strategy with an apparently significant risk. But is the risk for this strategy truly $1,757.90? Theoretically – academically – $1,757.90 is the max risk, but this situation only occurs if GDX drops to $0, an impossible situation that equates to all gold miners going bankrupt.

In practical terms, the max risk is actually $108 – the price of the option. Why? Because while the call option can possibly expire out of the money (i.e., GDX never reaches $21.50), the put option will be profitable nearly 100% of the time.

The chart below explains why:

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Since 2006, GDX has only dropped below the $16.5 point (the strike price of our sold put) twice. During those two times, GDX only stayed below the $16.50 threshold for under three months. This is why we are playing with options three months out: It gives GDX plenty of time to rebound from a dip below $16.50.

In fact, GDX does not have to be above $16.50 for our put option to break even; time decay will eat away at it. Thus, in any practical and historical sense, as long as GDX is above $16 sometime before our options expire, our max risk is only the price of the call option: roughly $100. Yet the upside for this strategy is unlimited.

The strategy of a reverse collar is actually a lot safer than a similar strategy that I use to mimic stock: the synthetic long. In a synthetic long, you sell a put of the strike price equal to that of the bought call. The reason I am recommending a reverse collar in the case of GDX lies in the mere $100 risk from a practical perspective; even considering the facts outlined in the chart above, a synthetic long position on GDX would have a risk of roughly 5 times that of the reverse collar.

However, one important similarity between the reverse collar and the synthetic long is that they both require margin. Check your broker’s margin requirements before opening a reverse collar, as you will need to maintain cash in your account as margin. We don’t intend to ever dip into this margin, as the loss control hinted at above will save us from doing so.

Loss Control

Said loss control is limiting our risk to the $100 for the call option. Should GDX dive below $16.50, we simply wait until GDX comes back to above $16.50 – as it has historically done – and sell our position at a $100 loss. Of course, history cannot always predict the future, so in the case of a black swan event in which GDX stays below $16.5 for more than three months, we simply sell at the day of options expiration (every $1 dip below $16.50 will cost us roughly $50).

Overall, the reverse collar on GDX is an aggressive strategy for both gold bugs and bottom fishers. As I have already painted my bullish thesis on gold, I reiterate that now is the time to develop a strategy on playing the future rally. You can either play aggressively and strike it rich as one of the gold rush pioneers or you can take it easy. The strategies are, respectively, to play one GDX collar or to buy 120 GLD shares (these should be equally profitable for an equal unit rise in gold prices).

Both are realistic strategies that will pay off well in the upcoming rally. The real question is whether you’re willing to spend $100 for the aggressive strategy or $12,000 for the safe strategy. When you lay the numbers down like this, perhaps the reverse collar is in everyone’s best interests, regardless of your risk profile.

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Note:  Damon Verial is the author of this article.

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Category: Commodity Options Trading

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