Trade Idea: An Inflation Trade with a Little Room for Error

inflation-options-trade

I came across an interesting infographic earlier this week.

I’m still trying to dig in deeper to see if there are any opportunities to be had from the information given, but I will say that the infographic did spark some other ideas within the commodity sector.

periodic-table-commodities-gld

As we all know, inflation is here. How long it lasts is anyone’s guess. Hell, the Fed for months said we shouldn’t worry; now it seems the rhetoric has changed. None of it matters, because the facts state what we need to know and that is that inflation is happening at an ever-growing pace. The question is, how can we take advantage?

Simply stated, gold – but with a twist.

For the past year gold, as seen through SPDR Gold Shares ETF (GLD), has been trading in a range between roughly 160 and 180.

Where it heads next is anyone’s guess. However, we do have a few strategies that we can use to take advantage of the popular commodity, especially when we take a closer look at the expected move for the February expiration cycle.

GLD-expected-move

As you can see, the expected move for GLD for the February expiration cycle is from roughly 165 to 175, so my goal would be to place a trade outside of the expected move.

An iron condor would certainly be a viable strategy choice. I could sell the February 180/185 and 160/155 iron condor for roughly $0.40.

Obviously, this is a very conservative approach as my probability of success would be 89.47% on the downside and almost 89.98% on the upside. Of course, the high-probability trade is reflected in the premium of only $0.40, but the return over 35 days is still a respectable 8.7%. Annually, that’s close to 100%. Not bad for a trade that has a 90% probability of success. All it requires is for implied volatility to stay around similar levels.

But I want to take a look at an alternative trade using a bull put spread.

A bull put spread, otherwise known as short put vertical spread, is one of my favorite risk-defined options strategies.

As the name of the strategy implies, a bull put spread is, well, a bullish-leaning strategy.

But it is important to note that the strategy doesn’t require the security to move higher to make money. With bull put spreads you not only have the ability to make a return when a security moves higher, you can also make money if the stock stays flat or even if the stock pushes slightly lower.

The first step in placing a bull put spread, or any trade, is making sure the security we are interested in is highly liquid. We always want to use the most efficient products possible. It just doesn’t make sense to have to make 5% to 15%, possibly more, to get back to breakeven.

SPDR Gold Trust ETF (GLD)

GLD is a highly liquid product, so we can move forward with a potential bull put trade.

With GLD trading for 170.10 and near all-time highs I want to place a bull put spread with a high probability of success.

GLD-gold-shares-stock-chart

The February 18, 2022 expiration cycle with 35 days left until expiration fits the bill. As a result, let’s take a look at the put strike with approximately an 80% probability OTM (out-of-the-money), otherwise known as the probability of success on the trade.

It looks like the 164 put strike with a 79.60% probability of success is where I want to start. The short put strike defines my probability of success on the trade. It also helps to define my overall premium, or return on the trade.

GLD-bull-put-spread-february-expiration-cycle

Once I’ve chosen my short put strike, in this case the 164 put, I then proceed to look at a 3- strike wide, 4-strike wide and 5-strike wide bull put spread to buy.

The spread width of our bull put helps to define our risk on the trade. The smaller the width of the spread the less capital required. When defining your position size, knowing the overall defined risk per trade is essential. Basically, my spread width and my premium increase as my chosen spread width increases.

For example, let’s take a look at the 5-strike, 164/159 bull put spread.

The Trade: GLD 164/159 Bull Put Spread

Simultaneously:

Sell to open GLD February 18, 2022 164 strike

Buy to open GLD February 18, 2022 159 strike for a total net credit of roughly $0.45, or $45 per bull put spread

  • Probability of Success: 79.60%
  • Total net credit: $0.45, or $45 per bull put spread
  • Total risk per spread: $4.55, or $455 per bull put spread
  • Max Potential Return: 9.9%

As long as GLD stays above our 164 strike at expiration in 35 days, I have the potential to make 9.9% on the trade.

In most cases, I will make slightly less, as the prudent move (and all research backs this up) is to buy back the bull put spread prior to expiration. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.45, I want to buy it back when the price of my spread hits roughly $0.20 to $0.10.

Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to lead the way for our decisions. But, taking off risk by locking in profits is never a bad decision and by doing so, we have the ability to take advantage of other opportunities the market has to offer.

Risk Management

Since we know how much we stand to make and lose prior to order entry we have the ability to precisely define our position size on every trade we place. Position size is the most important factor when managing risk, so by keeping each trade at a reasonable level (I use 1% to 5% per trade) allows not only the Law of Large Numbers to work in your favor…it also allows you to sleep well at night.

Moreover, I like to take off the trade if my original credit, in this case $0.45, reaches 1x to 2x my credit. So, I would look to take off the trade if it hit $0.90 to $1.35.

 

As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below. And don’t forget to sign up for my Free Weekly Newsletter for weekly education, research and trade ideas.

4 comments on “Trade Idea: An Inflation Trade with a Little Room for Error

  1. Ken Lumley on

    Andy, Tasty follow the same general rules you support. They mention, “take profits at 50% or “manage” at 21dte”. Does this mean that if a 2x exit point was hit before 21dte they’d stay in until 21dte and then exit (whever it was)?
    THANKS, enjoy the MLK holiday . KL

    Reply
    • Andy Crowder on

      Ken,

      I’m not really sure what Tastytrade does, I don’t follow the 21dte rule, so I’m not sure what they would do in that case. I keep a close eye on delta (probabilities) going into the last week of the trade as gamma becomes an issue. Typically, I try and get out of trades prior to expiration week due to gamma risk. I hope this helps.

      Reply
  2. Mike on

    I like setting up the trade so my risk/reward is 3:1 or better (usually only take 1:1 trades).
    The way you measure this is as follows. Look at a Risk Graph. What is your loss if the stock hits your short strike (assume this happens immediately because you want to calculate this before you enter the trade). Compare that risk to your return assuming you will take profits at 50%.
    Move forward if 3:1 or less.

    Reply
    • Andy Crowder on

      Mike,

      Thanks for writing in. Everyone has their own way of trading. I tend to use something similar, but again, position-size is what truly keeps me in check. Thanks again for writing in and sharing the way you manage risk.

      Reply

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