I spent nearly an hour today trying to figure out how to make a worthwhile options trade on GLD. I think the gold ETF is going to move higher soon, but I couldn’t decide on an order that would manage my risk for the little reward I was getting. Finally, I turned back to SPY, one of my favorite ETFs to trade options on. I’ve been increasingly bearish lately and wanted to open some exposure that could play on that sentiment, but didn’t cost me much in case I’m wrong.
I saw that selling a put spread would be close to fitting what I wanted. I don’t think the downside risk in SPY is massive, but do expect a retracement of this year’s gains to some extent, maybe another 4-5%. Since my opinion of the risk limits to the downside are relatively small, buying a put spread made more sense to me than just buying a put. I didn’t need to try to profit from an all-out bear-market because any sell-off isn’t likely to send us off a cliff. I only needed to profit from the first few percent of downside. Once I was convinced that I should buy a put spread, I had to pick which one. I looked at March, April and May expiration. March seemed too soon. I’m fairly confident SPY is heading lower, but it might take longer than just three weeks (probably not). May was probably better since it allowed enough time for my theory to play out. I almost went with May contracts, but decided I needed to trust my judgment that a dip was coming sooner than later. April made more sense. By working the April contracts, I could have enough time to get a near-term dip and can exit before the ETF rebounds.
Before I placed my order, it dawned on me that if I only expect 4-5% of downside, I could sell some naked puts along with this order to pay for it. I went almost 5% below the recent high ($153.28) for SPY and figured the risk from there ($146) wasn’t too bad, especially if I was going to make money from my long put spread before the naked puts came into play.
While SPY was trading at $150.75, I bought to open two April $151 puts for $3.62 and sold to open two April $145 puts for $1.735. I paid $380.38 for the $6 spread after paying $3.38 in commission. As soon as that order hit, I sold two April $146 naked puts for $1.95 each and received $389.06 after paying $0.94 in commission. That amounts to a net total of $8.68 I’m starting off with as a profit if SPY moves back above $151.00. If the S&P 500 index ETF stays below $151.00, my profit will grow until it drops to $146.00. That’s 3.1% below the price of SPY when I made the trade and 4.75% below its recent high.
I’ll reach my maximum profit if SPY hits $146.00 (not counting time value over the next eight weeks). I’ll have a profit of $819.62 from the put spread and an additional profit of $389.06 from the naked puts. Together, that’s $1,208.68. The decline starts eating into my profit for every tick below $145.00. I could’ve included all three trades in one order if I had planned it like this from the beginning, but since the additional short puts were an add-in at the end, it was quicker to just make the additional trade. It’s the same combination as selling a $151/146 put spread with a $145 naked put added on. I just didn’t execute it that way.
Every penny below $146.00 locks in my profit between my long puts at $151 and my short puts at $146. I don’t have a profit/loss change between $145.00-146.00. If SPY falls below $145.00, I start losing profit, but this doesn’t turn into a losing trade until the losses on my naked puts exceeds the gains on my put spread.
This is how it adds up based on the way I traded it. At $145, I’ll have a gain of $4.10 per share from the put spread and a gain of $0.94 from the naked put (that’s after deducting $1 of the naked puts’ intrinsic value). That gives me another $5.04 to work through before I start losing money. This might be easier to understand as a fully combined trade. If my put spread makes a full profit and I take the assignment on the naked puts, I will have a combined $6.04 in realized gains and will have bought SPY at $146.00. $146 minus the premiums of $6.04 equals a cost per share of $139.96.
I lose two pennies for every penny SPY trades below $139.96 since I have two of each contract. The good news is the losses don’t start until SPY falls 7.15% from where it was when I made the trade and 8.69% below the recent high. By the time the market closed today, it was heading in my direction. I’ll be comfortable until it passes $145 and then I might have to think about creating another order that’s built the same way at lower strikes. I could continue to work similar orders on the way down until it turns it works out. I only have this flexibility because I timed this dip well and didn’t have much capital at risk going into today.