In part one, I showed you how you can insure profits of your position without closing it. At first glance, everything seems clear but theory and practice sometimes differ. You may face many problems when insuring revenue of your portfolio especially when its ingredients are less popular instruments. Here I want to show you what problems to look out for when you choose to use options.

1. Buying wrong option


When insuring profits of your portfolio you want to choose the least-costly way to do this. The premium – price of an option – is made of 2 components: a) Intrinsic value; b) Time value. First, one is the intrinsic value of an option. This shows you whether given option is at the moment profitable (in the money) or in the red (out of the money). 


When an option is ITM you could make a profit by selling it now. For the put option, this is happening when the price of the underlying asset is lower than the strike price of the option. For our strategy, it wouldn’t be optimal. We need an option that can make money the closer it is to the premium we are buying it for. Otherwise, it could cost us more than just the premium.

Source: Self-Made

An out of the money option currently generates a loss. We see it when the strike price of the put option is much below the price of an underlying asset. This option is cheaper as we only pay for its time value – time that is left until it expires. Our strategy may fail in these circumstances as the underlying asset can further depreciate and our option would not make enough money cover this loss.

Source: Self-made

The second part of option’s price is its time value. Even if an option is in the red it still has some value deriving from the time that is left until its expiration. Still there is a possibility of an event which can change the pricing of an underlying asset and as a consequence put an option in the positive territory of our profits.

What option should you buy then? Personally, in most cases, I choose option ATM (at the money) with expiry date similar to the time horizon of my investment. At the money option has its strike price very close to the price of the underlying asset. This makes the strike price of this instrument consist of only time value and no intrinsic value. Great idea is to buy an option with a similar expiry date to planned closure of our planned investment. If we close our position earlier we can always sell the option for additional profit.

2. Market not popular? Be ready for low liquidity

The biggest problem we have to have in mind is the market liquidity when it comes to buying or selling options. The non-liquid market gives fewer opportunities and makes options more expensive. The premium we would have to pay is going to be lower the more liquid the market is making it less costly for our insurance to work.

Buying an option imply that someone has to be selling it. Low liquidity translates into less variety of options with a strike price that will fit into our investment strategy.

Another problem of the non-liquid market is a small variety of options due to their expiration date. Insuring our market position we plan to close in 2 months the only options we could be left with are those expiring in few days or half a year. We can always play safe and buy the option with later expiry date but selling such an option after closing our position may prove very hard. It goes without saying that price we are going to get can be considerably lower than anything we had in our mind.

It is a good idea to stay away from buying options in niche markets with a very low number of transactions.

3. Risks arising from securing underlying asset

This article comes out in the environment of ever volatile markets. Many of you invest in precious metals and it is important to understand what underlying asset you will be buying your option on. Typically, options are basing on a futures contract and this, in turn, is based on gold, GLD or GDX.

Solvency of the parties is crucial today. Among big private institutions, investment in physical gold is far from being the most popular. They choose to buy a share in GLD or invest in mining stocks GDX. Trader21 touched this topic of mining companies in the article called “Mining companies – trap or opportunity?”

Among institutional investors, the most popular gold fund GLD was very popular. The same fund was omitted by Trader21 as it is an evident trap for investors. The official story is that GLD is based on physical metal, therefore buying a share of it gives the same effect as buying an ingot. That is not true. It is an open secret that GLD was cleared from all metal to fill the holes in supply. GLD regulations are construed in a way that in a case of gold’s price surge, the fund can close investor’s positions without his consent leaving him only with a fraction of the actual profit. On top of that there it is possible that performance of the fund and physical gold can go opposite ways. Physical metal in this situation would go up and GLD and gold futures record losses.

Sprott’s ETF is better in my opinion. It is in fact secured with physical metal. When discrepancy between performances grows, fund climbs faster than Comex’s price of gold.

Another problem is Comex itself and its CME exchange where futures and options (including options on assets that you won’t find there) are traded. We have to pay attention to solvency of options’ sellers, possible suspension of trading that happened before and continuation of correlation between a futures contract and physical metal. It is getting harder to find gold as security of futures or delivery of a forward contract. More and more probable the scenario of misalignment of COMEX and Chinese gold exchange where the actual metal is being traded.

4. Hedging transaction, example of GDXJ fun investment

Let’s assume that on 15th January we bought shares in GDXJ fund, 17 USD each. Gold in dollar terms was at 6 year low. With a price bounce of the metal, small mining companies’ performance also went up. In just 3 months each share gained 95%, up to 33 USD. The surge was strong and quick making the result of this investment very satisfying.

Finally 14th April came and GDXJ share dropped to 31.2 USD. We start to wonder whether selling at least portion of our portfolio. We have to make a decision: closing position or counting on more gains. There are good arguments behind both choices.

In favour of further gains:

- Admission of precious metals manipulation by Deutsche Bank;

- Breaking through short (50-day) moving average of long (200-day) moving average from the bottom which is one of the strongest signals of technical analysis telling us about change of trend from losing to gaining;

- Ever worsening situation in equities and bonds market.

 

In favour of further losses:

- Strong and quick bounce back after which should be followed by a correction;

- Recent capitulation of DB will not stop practice of manipulating precious metals’ prices and banks may want to break recent bounce and return to lower prices;

- Slump in the market which can cause big discounts of gold futures’ price, similar to situation of end of the 2008 year.

We can continue gathering arguments for and against or hedge just like it was explained by the previous article “Options as insurance of our profits – Part I”. This is why we are going to buy a put option on GDXJ fund. This costs us 1.5 USD and its expiry date is in one month. This insurance costs us more than 10% of our profit that we earned. We can hold our position, wait for another month with secured profit and hope for even bigger revenue.

If the time period of 1 months is too short for us we can buy 7-month option for 4.4 USD. This is nearly triple price of the previous one but 7-fold increase in its length. When we will sell our original position we can also sell this option afterwards.

Price of gold experienced a serious rebound and even if we believe that this is the moment the trend will change we can be a bear for a short term and short sell. Eight-day put option costs 1.25 USD and before it expires we can secure our position against correction during this period. I expect it to happen as after surge it is natural to see short period of discounts. This action is speculative but very cheap to accomplish.

5. Securing your position with related assets

Although there is a variety of choices when it comes to securing your position – especially in developed markets with strong financial sector – it may be hard to do so when your asset is not a good or an index.

What we can do is to secure our position with another one which is very strongly correlated with ours but this correlation must be negative. For this it’s worth checking how both assets performed in respective time frame.

For example: if after buying gold you want to secure your position with an option on GDXJ, you compare how they performed. Since January until March, price of gold climbed from 1070 to 1260 USD and the price of GDXJ reached 27 USD from its original position of 17 USD. In the first instance you see increase of 18% and the other of 60%. You can imply that in the future fund would react in a similar way to gold but 3 times stronger.

Apart from researching strength of the correlation it is important to check whether during violent sales or random events affecting the price of our asset this correlation is holding. Very often we could see how asset linked together for years lose their correlation due to bankruptcies, catastrophe or political decision.

Volatility and correlation are given near each asset by brokers on their transaction platforms – we don’t need to keep finding it on our own. Just compare the right assets and data will be on your screen. Correlation is easily understandable but volatility is given in a form of standard deviation. On this blog you won’t find maths lessons so it’s up to you to research that if you are determined enough.

Securing your position with related or at least correlated assets is still pretty risky and I wouldn’t advise any beginner to us it.

6. Options as a speculation

Many people use options to speculate. This may seem as a pure gamble on their side but it is not. You can for example buy a call option which is very much OTM (in the red) that ends in few weeks. Thanks to the above it will be cheap. To make any sense of such position you have to know the probability of the underlying asset’s price to change.

Again, let’s use our GDXJ example. If we buy a call option on an index when it fell to 17 USD and price of gold was only 1070 USD/oz, we would pay for it approximately 2 USD. After 3 months our profit would be 8-fold as price went up from 2 USD to 16 USD in only one quarter. Knowing this, even if we would have been in the negative area with our 4/5 options on different assets – we should be fine. The most important factor is to find an opportunity and judge it responsibly.

The technical analysis and many indicators measuring sentiment level may help us in finding those opportunities. Good example of the above is the CRB Index Optix.

Source: gold-eagle.com

Using those indicators showing extreme deviations of the sentiment in one way or another significantly increase our chances to successfully speculate. Extreme fluctuations in investor’s sentiment are rare but when they happen, they are great chance to make money.

Market always gives new possibilities to speculate. One of them right now is liquidity problem of Saudi Arabia. Saudis are engaged in costly wars and spending on huge infrastructural projects like the new Suez Canal, all this while barrel is very cheap. What is more, Americans use their political domination to prevent them from selling their reserves – US government bonds. This pushed Saudis to print their own bonds to patch the strained budget.

The main problem is ballooning social spending. There is an easy solution. The KSA could make it easier on themselves by removing USD/SAR peg at 3.75. Here is our chance to make money. We can buy a call option betting on USD to strengthen against SAR.

Of course, we have to understand that Saudis have tenacity and their persistence was seen many times for example during limiting of oil production negotiations. Recent addition of allegation of Saudis being involved in the WTC attacks makes this puzzle even harder to crack. What length of our position we should be looking for? The longer we give the Kingdom to change their mind the more we will have to pay for the option.

Why options and not futures? Simply put, price of option which is deeply OTM is low. Thanks to that we are risking very few USD betting on big potential profits. Also, in case of deep OTM option turning out to be even deeper we will lose only the price of an option. This wouldn’t be the case if we chose futures contract.

Summary

However safe the strategy to secure your profits may seem, they have several disadvantages. The best example of this is the Black Monday of 19th October 1987. It was further worsened by this type of plans.

Many managers of investment funds bought variety of contracts to insure the value of their investments against declines. When they came they started to sell assets to make a correction in their portfolios. Sell of contracts and equity not only made their strategy to be useless but it blew back making 19th October a Black Monday. It was the day that Dow Jones lost 22%.

You can be assured that there are more risks of this strategy. This is why I want to highlight the need for you to research and be cautious especially during our times – times when interventions and manipulation by central banks are becoming a norm.

 

Independent Trader Team