Embracing Volatility… How to Use the Put-Sell Strategy to Grab Stock Discounts and Cash

by Lee Lowell, Stock and Commodity Option Specialist
Friday, March 26, 2010: Issue #1225

When I was a floor trader on the NYMEX in the 1990s, a “big” day occurred when oil futures moved by $0.50 intraday. And it would take all day for that to happen.

Today’s fluctuations make those days look like bingo night at the church hall.

It’s not uncommon to see the price of oil move $2 in mere seconds. And intraday moves can easily span $3 to $4.

The question is: Why such a dramatic change between then and now?

I chalk much of it up to the new electronic technology in the market today, which has opened the door for many more investors. All you need is a commodity trading account and you can be in the market in a flash. That’s led to commodity trading seeing a surge in popularity over the past few years.

In addition, you’ve got large, speculative moves from hedge funds and institutions, which only makes the moves bigger – often whipping markets into an all-out frenzy in the process.

Some investors curse this volatility. But they’re missing the point. Volatility is the engine that drives profits – particularly with commodities. And if you know what you’re doing, there are some great trading opportunities…

How to Profit From Oil’s Big Moves… With Little Risk

Take the oil market, for example…

• After the price hit its 2010 high of $85 back on January 11, it then plunged by $15 per barrel in just one month. That equates to a $15,000 move on one futures options contract.
• Many thought the market was ready to fall even further. But in typical fashion, the price rallied back up to $83 just as fast – another $13,000 move on one contract.

At the moment, crude oil is hovering around $81 per barrel. If you want to get involved, the easiest way is to look at the ETF that tracks front-month oil prices – United States Oil (NYSE: USO).

If you want to invest in the market more directly, you can go for futures options, which trade on the NYMEX.

• If You’re Bullish: With the momentum currently pointing higher, buying call options, or using strategies like call option debit spreads, offer limited risk with unlimited reward.
• If You’re Bearish: Right now, this would be a contrarian play. But if you want to play the downside, you can buy put options or put option debit spreads.

Either way, select options that expire in three-to-six months time (June 2010-September 2010).

Sudden, wild moves aren’t restricted to the oil market, though. We’ve seen gold trade the same way. But again, if you know how to capitalize on the moves for as little risk as possible, you can beat 99% of the “regular” crowd.

Heck, you can even get paid for it, too. Let me show you how…

The Easiest Way to Play Gold

As 2009 ended, gold futures topped out at $1,230 per ounce. But after a fast start to 2010, the price dipped back to $1,045.

This is when it’s crucial to look at technical support levels. These are areas below which the price generally won’t fall before buyers re-enter the market and shore up the price.

With gold, solid support came in around the $1,020 area back in February. Sure enough, the decline stalled just short of that level and gold rallied again – all the way up to $1,140 per ounce, in fact.

To see the chart in it’s original size, click here.

Since then, we’ve seen gold prices drift down a little. But as I mentioned back in December, I believe we’ll see another strong year for the gold market, interspersed with bouts of profit-taking.

Like oil, it’s easy to play the gold market through an ETF. The most popular and liquid one is the SPDR Gold Trust (NYSE: GLD), which tracks the price of front-month gold futures.

This is exactly what we did in The White Cap Report recently…

The Benefits of Executing a Put-Sell Trade on GLD

As we’ve seen in the commodities sector many times, once a market gets going, it doesn’t take much to bring the big hedge funds and institutional traders (i.e. speculators) to the table. This merely intensifies the bullish fever.

With that in mind, we used a put-sell strategy on GLD that would accomplish three things…

• Take advantage of the upside.
• Allow us to participate for minimum risk.
• Put money in our pocket just for executing the trade.

We did it by selling the December 2010 $85 put options on GLD for $1.60 per contract. Here’s what the trade gave us:

~ Cash: Because there are 100 underlying shares in each option contract, that immediately put $160 in our account ($1.60 multiplied by 100 = $160) for every contract sold.

~ A Discount: When you implement a put-sell trade, you basically get to name the price at which you’d be comfortable buying the underlying shares. In this case, the aim was to buy GLD for $85. At the time, that was $27 less than the price of GLD – a 32% discount. So if you sell one put option contract, you’re obligated to buy 100 shares of GLD for $85 per share. This is the equivalent of gold trading for $850 and represents a great long-term play.

So how do you manage a put-sell trade?

The Two Put-Sell Scenarios

When you execute a put-sell trade, you’re essentially reversing a regular stock purchase. You’re simply selling the put options before either buying them back at a lower price and locking in a profit.

Or, if you hold until options expiration, there are two scenarios:

• If GLD trades below $85 by December 2010: We’ll be obligated to buy the shares for $85. We’ll own the shares and must manage the position like any other regular long stock holding.
• If GLD closes above $85 at December 2010: The put options will expire worthless and we’ll keep the $160 that we received when we executed the trade. That’s the maximum gain and the trade would then be closed. So although we wouldn’t be able to buy GLD for $85, we’ll at least get to keep the money from selling the options.

For any put-sell trade, you must be prepared to buy the shares if you’re called upon to do so. In this case, that means you’d have to buy 100 shares for every put option contract you sold. Your broker will require you to keep a portion of the total value available for the duration of the trade – a “margin” requirement.

At the moment, the GLD December 2010 $85 puts are trading for around $1. That means we could bank a $0.60 profit per contract if we chose to buy them back. But since there’s plenty of time left until expiration, we’re holding.

Good investing,

Lee Lowell

2 Responses to “Embracing Volatility… How to Use the Put-Sell Strategy to Grab Stock Discounts and Cash”

1. Don Lowry Says:
   
   March 26th, 2010 at 5:09 pm

   Unfortunately, my broker won’t let me sell naked puts. I imagine others have the same problem.

   Reply

2. R. Li Says:
   
   April 4th, 2010 at 8:15 am

   I cannot understand how gold can be transacted at $85.- per oz when the the current price is over $1,000.-
   I suggest that if one is bullish about a metal, one can sell put below the current price to get premium which can utilised to pay for buying a call above the current price. Vanilla put does not let you participate in the increase of price of the metal.
   Ronald Li

   Reply

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