Lawrence G. McMillan discusses Gordon Gekko's trade.
This All-Star Commentary post features a Trade Note from Gordon Gekko. Thanks for sharing with the Community!
"I think Gold was quite speculative and it's time for a reversal." - Gordon Gekko long put entry
Gordon,
Thanks for letting us in on your recent thinking about Gold and GDX. We'll go right to the Rookie's Corner to bring everyone up to speed on your long put play.
ROOKIE'S CORNER
GDX = 47.78 as of 3/20/08
3/19 1:05 pm Trade 1: Bought to open 1 GDX June 45 put @ 2.55
GDX = 49.37 as of 3/19 close
Long Put - Play #2 (Education > The Options Playbook > The Plays > Play #2)
A long put gives you the right to sell the underlying stock at Strike Price A (45). If there were no such thing as puts, the only way to benefit from a downward movement in the market would be to sell stock short. The problem with shorting stock is you're exposed to theoretically unlimited risk if the stock price rises. Puts may be used as an alternative to shorting stock, because they limit your risk to the cost of the options. If the stock goes up - the worst-case scenario - you don't have to deliver shares to the investor from whom you borrowed them, as with short stock. You simply allow your puts to expire or sell them to close your position (that is, if they're still worth something).
BREAK-EVEN AT EXPIRATION
Strike A minus the cost of the put. (45 - 2.55 = 42.45)
THE SWEET SPOT
The stock goes right in the tank.
MAXIMUM POTENTIAL PROFIT
There's a substantial profit potential. If the stock goes to zero you make the entire strike price minus the cost of the put contract. However, stocks usually don't go to zero.
MAXIMUM POTENTIAL LOSS
Risk is limited to the premium paid for the put.
MARGIN REQUIREMENT
After the trade is paid for, no additional margin is required.
AS TIME GOES BY
For this play, time decay is the enemy. It will negatively affect the value of the option you bought.
IMPLIED VOLATILITY
After the play is established, increasing implied volatility is your friend. It will increase the value of the option you bought. It also reflects an increased possibility of a price swing (without regard for direction).
TRADE DISCUSSION and RESEARCH
This is, of course, a simple position - bearish speculation on Gold. Even so, there are certain calculations that the trader should do in order to evaluate his alternatives as to which option to buy.
So, using a Black-Scholes model with these inputs:
Expiration date: 6/20/08
Strike price: 45
Stock Price: 49.37
Evaluation Date: 3/19/08
Risk-Free Interest rate: 2.25%
Put Option Price: 2.55
Dividend: $0.745 on 3/24/08 (don't forget to check the dividend, especially when they're this big!)
We find that the implied volatility paid for this put is 44.8% (for more on Volatility, click here).
That is right in line with current implied volatilities for GDX options, but how does it stack up historically?
Figure 1 shows the last year's stock chart and the implied volatility chart of GDX options over that time. As you can see, 44 is a bit on the high side (actually, it's in the 92nd percentile of implied volatility readings over the life of GDX options). However, you pretty much have to pay what the market is asking, so I really have no problem with paying 44 vol for these puts.
Click here for a larger image.
There is always some argument over whether one should buy an in-the-money or an out-of-the-money put, but we really don't know that much about your thinking. (My preference is usually in-the-money, but you must come to your own conclusions as a self directed investor.) If you are looking for a major decline in the price of gold over the next three months, the choice of the June 45 put may be fine. If you are looking for less of a decline, an in-the-money put may be the better choice. (Choosing which option to use has to do with Delta, click here to read more.)
Personally, in speculative situations, I tend to lean to short-term in-the-money options, figuring I will roll them out if I want to stay in the position longer. So, something like the April 50 or 52 put might have been my choice, but there is no absolute reason to say that's necessarily better. Again, we each must do our own research to support our individual decisions.
However, there is one thing in your comment that I see that might cause some problems: "I think Gold was quite speculative..." This ETF is composed of Gold mining stocks. That's not the same as Gold itself. Figure 2 shows a continuous price chart of Gold futures (which is essentially the same as the metal itself). Note the difference between that and the stock chart in Figure 1. Gold was in a strong uptrend since last August, but GDX has spent much more time going sideways. The difference between these two charts is most obvious starting in January of this year.
In fact, GDX is much more in line with the PHLX's Gold & Silver Index ($XAU). While it's certainly true that the price of Gold and the price of gold stocks are related, they are not mirror images of each other. So, if you were truly speculating on the price of Gold - the metal - you may not have bought puts on the correct underlying. There is an ETF that tracks the price of gold (symbol: GLD), but because of a jurisdictional dispute between the CFTC and the SEC, there are no options listed on GLD. The only way to actually buy puts on Gold itself is via the futures market. (TradeKing does not offer Futures trading at this time. Although not an ideal tracking instrument, GDX may have been a viable choice to reflect your idea.)
Click here for a larger image.
GDX is already back down to support in the 45 area, and has retraced a major portion of its advance since last December. However, Gold itself could fall farther, as it has not yet even retraced significant portion of its advance since last December. If Gold futures continue to decline, GDX might stabilize near support. With this information in mind, I would definitely have preferred to buy the higher striking price puts. Either that, or buy puts in the futures market on Gold itself, rather than a put on a gold stock index. But, this is still a reasonable speculation. Good luck with it.
This comment and any market data included here were prepared on 3/23/08.
President
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Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
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