Good trading ideas are everywhere. This is particularly true for individuals who are willing and able to move beyond the traditional, "As a savvy investor focused on the long-term, which stock or mutual fund should I buy for long-term capital appreciation" AAAAAARRRRRGGGGGHHHH, is that a stock market collapse!?!?!?!?!?, Hhhhhheeeeeelllllllpppppp me!" method of investing.

The vast majority of individuals view and prefer to characterize futures and option trading as "risky speculation." Ironic then, isn't it, that despite even the roughly 40% gain by the stock market since March, these investors' net worth remains at least 40 to 50% underwater from their levels of just 18 months ago.

Looking for Ideas

One place I like to look for ideas that I typically would not think of on my own is "The Striking Price" column in Barron's Financial Weekly, typically written by Steven Sears. Of course, human nature being what it is, I more often than not prefer to take any new idea and try to improve it. Let's look at a case in point. WARNING: I am about to try to make myself sound smarter and more inquisitive than someone else - hey, everybody has a dream.

In his piece last week, Sears talked about an idea from Sveinn Palsson at Credit Suisse that involved buying one January 100 call option on GLD and selling two January 120 call options. Now I'll admit I've always been a little leery of guys named Svienn, but hey, once an Ugly American always and Ugly American, I guess. In any event, it turns out that Mr. Palsson was on to something as the thought behind the trade is that the farther out-of-the-money calls are trading at a higher implied volatility and that a trader can gain an edge by selling more of this option (i.e., the 120) than the one he buys (i.e., the 100 call). Let's take a closer look at this trade and also consider a potential alternative.

The Original Trade

The original trade in question goes as follows:

Buy 1 January GLD 100 call
Sell 2 January GLD 120 calls

While I think the ratio aspect is a viable trading tool, there is one thing about this type of trade that tends to get glossed over. Typically, the statement you hear is that "the trade has unlimited risk if the underlying security (GLD in this case) is above the upper strike price at expiration." The implication then is that risk is minimal because GLD would have to rally from 93.56 (its price as this is written) to above 120 by expiration in order for this position to get into trouble. But this is not actually the case. In fact, although this trade is bullish in nature, the irony is that the worst thing that could happen would be for GLD to explode to sharply higher levels anytime soon. Let's look at why I say this.

Figures 1 and 2 display the profit and loss figures and the risk curves, respectively, for this position, leading up to expiration in January 2010.

Figure 1 - GLD Jan 100-120 1x2 Ratio call spread

Figure 2 - Risk curves for GLD January 100-120 1x2 ratio call spread

If you look only at the black line in Figure 2, which displays the expected profit or loss as of January expiration, you can see that at January expiration this trade would show a profit if GLD is between roughly 101 and 139. But if you look at the other risk curves prior to expiration, something important jumps out. If GLD rallies sooner than later this position has little ability to actually generate a profit. And if the desired goal of GLD advancing sharply happens too soon, a trader might find himself having to act to cut a loss before it gets out of hand.

Now please understand that I am not saying that this is a bad trade. The real point is that in considering any option trade it is most often useful to also consider some alternative trades to see if you can find a better tradeoff between reward and risk. So let's take Mr. Palsson's original idea - which again, in all candor, I would not likely have thought of on my own - and see if we can improve upon it.

An Alternative Trade

Let's make two fundamental changes to the original trade. First off, let's change it from a short ratio spread (i.e., a position that is short more options than it is long) to a traditional butterfly by purchasing one 100 strike price call, selling two 120 strike price calls and also purchasing one 140 strike price call. In technical terms we are building an "out-of-the-money butterfly" spread. Also, because butterfly spreads gain the most ground as expiration nears - and assuming you get direction right in the case of an OTM butterfly spread - we will also switch to September options, which have 102 days left until expiration" still plenty of time for GLD to make a move.

Figure 3 -September 100-120-140 GLD Butterfly


Figure 4 - September 100-120-140 GLD Butterfly Risk Curves

A few key notes of comparison are in order. The Jan 100-120 1 by 2 trade has little dollar risk, yet also little profit potential if GLD stays below 100. If GLD rallies strongly, this position has unlimited risk.

On the other hand, the maximum risk on the Sep 100-120-140 trade is limited to a maximum of $204 on a 1x2x1 spread, both to the upside and the downside.

Now to fully compare apples to apples, let's look at the anticipated risk curves for both of these trades as of September option expiration. At that time the September options will expire, while the January option will still have 119 days left until they expire. The expiration risk curve for the September 100-120-140 is the black line in Figure 4. The 9/18/09 risk curve for the January 100-120 1 by 2 trade is the purple line in Figure 5.

Figure 5 - January 100-120 1 by 2 GLD ratio spread; Projected risk curves through 9/18/2009

As you can see in Figure 5, as of September 18, 2009:

• The Jan 100-120 trade would have a profit potential of just a few hundred dollars at best, assuming GLD was between approximately 82 and 125.
• The Sep 100-120-140 butterfly has a profit range of about 102 to 138.
• Please note however, that the profit potential at that time for the September trade is far greater than that for the January trade. If GLD happens to be between 105 and 135 at the time of September expiration the September 100-120-140 butterfly spread will generate a profit in excess of 100% with a maximum profit potential of about $1,800.
• Also note that prior to September expiration, the September butterfly enjoys much greater profit potential than the January 100-120 ratio spread. For example, if GLD happened to be at 118 by 8/15 (the green line in Figure 4), the September butterfly would show a profit of approximately $800. The January ratio spread (the green line in Figure 5) would be a breakeven and would start to lose money if GLD continued to advance.

In the most extreme example, if something cataclysmic happened and GLD opened tomorrow at $150, the September trade would be $204 in the hole and could lose no more, while the January trade would be $2,000 in the hole and could continue to lose more with each additional point that GLD advanced. This is clearly quite unlikely, but the point is this: if you are going to enter a bullish position, why not enter one that has some upside profit potential now and not just seven months from now?

Summary

So which is the better trade? The January 100-120 1 by 2 ratio spread or the September 100-120-140 butterfly spread? Well, as they say, beauty is in the eye of the beholder. As you might guess, I prefer the September trade (or why the heck else would I have written the article), but the fact remains that each trader must assess the risk and reward characteristics and make their own determination.

The real point is that it's always a good idea to keep your eyes open for unique ideas, and once you find them, rather than taking them at face value, do a little homework and see if you can find an even better approach. Same as it ever was.

Thanks again, Mssrs. Palsson and Sears.

Jay Kaeppel
Staff Writer and Author of "Seasonal Stock Market Trends"

Optionetics.com ~ Your Options Education Site

Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.

NOTES:

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