Category Archives: Trade Lifecycle

Trade lifecycle from trade entry, updates, adjustments and trade exit.

Long Nat Gas since Q1 2021

Natural Gas (NG) price has been consistently declining due to significant over supply for the last few years. In general there are consistent seasonal drawdowns of NG supply throughout a trading year, usually due to consumer energy demand for heating or cooling. Typically large drawdowns of NG supply in winter for home heating from November to March. However there can also be periodic supply drawdowns during summer heatwaves with energy demand for home cooling.

Natural gas is historically cheap on an absolute basis, but needs a catalyst to justify a longer term higher prices. The historically cheap price is encouraging countries to reevaluate its use. NG is not considered as “clean” as alternative energy being found near oil deposits. However practically energy will have to come from somewhere. As China’s climate change commitments force transition into “cleaner” energy solutions, they need to plug the gap between oil/coal and transition to alternatives like wind/solar. However NG could becomes up to 15% of China’s energy market by 2030 then that potentially increase demand and maintain pricing this decade. Taking the other side of the argument though, the increase in Chinese NG production into 2030 could dampen the NG price further by over supplying the market.

There could be a good decade long position trade here, but history shows that NG has been following the pattern of lower lows for many years. The following chart shows the Nymex natural gas futures price for Aug 2021 settlement. Starting at $8.88 in Nov 2008, down to a low of $2.21 in Feb 2020, followed by the current price with a bounce back to around $4 in July 2021.

Natural Gas (Aug 2021) futures price for last 13 years…

As the commodity price chart shows – it is hard to justify as a long “buy and hold” trade due to this secular bear market. However it’s rapid spikes make it an excellent trading vehicle, with the right timing. Fortunately 2021 appears to have produced a hot summer that has created a natural gas trading catalyst – so there is no need to wait until 2030 to find out how the trade performed…

Long Hot Summer

The main short to medium term factor driving NG prices is energy demand due to higher than normal US temperatures. Natural gas as a fuel has a different trading dynamic to natural gas producers stock (e.g. such as the FCG ETF). Natural gas price tends to trade off near term supply and demand (up to 6 months out), where as natural gas producer stocks tend to trade off medium to long term expectations for natural gas prices (often 12 months or more out in time). Additionally some producers have locked in contracts (“hedged” pricing) – so short term near month price changes don’t impact longer term prices that could be locked in or haven’t moved that much. The /NG futures curve as of July 2021 is an good example of this phenomena:

Natural gas is not a “forever” trade. However the short term market supply issues mean that pricing can potentially spike in the next few months. One of the main trading vehicles for natural gas is the UNG ETF that attempts to track the commodity price. The implied volatility on UNG options is certainly showing that a large move is possible – with implied volatility moving up from about 30% to over 50% in the last month.

However the July 2021 future curve (from Nymex natural gas futures) is implying a return to “normal” pricing in 2022. From a medium term trading perspective, any significant spikes should be used to reduce risk in the next few months.

The July 2021 futures curve is not always the shape of the commodity futures curve. Typically the main ETFs (such as UNG) that track NG have a structural decay problem, due to rolling futures every month. The ETFs do not hold natural gas as a raw commodity because of storage costs, so they maintain exposure using futures. Usually the ETFs futures holdings are near month to get as close as possible to the commodity spot price. However maintaining this position requires the consistent need to “roll” every month, usually when the near month future gets close to expiration. Rolling means selling the expiring near month and buying the next months future contract. This generates transaction costs every month, but more importantly roll costs can eat away at the capital in the ETF. The next section explains this roll cost in detail.

ETF Roll Cost

More importantly though for the Natural Gas ETF is whether commodity pricing is in contango. Contango is where the price of commodity contracts further out in time are more expensive. Futures prices out in time by many months are sometimes referred as “out on the curve”. The following graph that show an example commodity pricing curve in contango. This example is not for natural gas, so the exact numbers and dates are not that important – it is just a sample contango futures curve to show the idea.

Example contango curve (prices higher in the future)

Contango pricing plays an important part in the long term Natural Gas ETF (UNG) price. UNG typically holds near month Natural Gas futures to approximate the natural gas price. The near month futures contract is normally natural gas for delivery in the next 30 days or less. As the near month contract gets closer to expiration, the fund must roll into the next month’s contract to maintain exposure. If this is not done then the near month contract would expire, and the ETF would acquire several hundred million dollars worth of physical natural gas for delivery! Depending on the funds specific mandate, the “roll” may be done over several days and likely several days prior to expiration. The “roll” is a monthly process to maintain the price exposure.

Using the futures symbol for Natural Gas \NG the following example shows a roll between two separate months. The exact date and pricing shown is not as important as demonstrating the concept. For example if \NG August is $3.50 and \NG Sept is $3.55, then the fund has to sell $3.50 and buy $3.55. This generates a “roll cost” of $0.05 per month (difference between $3.55 and $3.50) just maintain the position. Additionally due to the higher price of the new purchased futures contract, the total number of futures contracts held by the ETF gets reduced. This price difference maybe relatively small (e.g. less than 1.5% of the fund) however compounded over time every month it adds up. This roll loss explains UNG terrible long term performance – as well the actual physical natural gas price trending down.

This chart dramatically shows why UNG is not a “buy and hold” investment, down more than 99% since inception:

UNG – not the best long term investment…

It is important to note that the opposite condition to contango can assist the Net Asset Value of the ETF. The reverse of contango is called “backwardation” – when futures prices out several months are less expensive than near month futures. Backwardation helps the ETF maintain value and only contango has the rolling issue above.

Avoid Buy and Hold

Commodity ETFs like UNG or USO that are often in contango and use near month futures to track the commodity price, should not be held for long term trades. They are tradable for daily or monthly trends, but not usually years.

The other important thing to note is that commodity ETFs using futures don’t always rebound after big crashes. Often contango rolling impact is greatly increased after a crash due to market dislocations in the front month. One extreme example has to be this year in April 2021 when the May Oil price briefly traded at negative $40, but month further out were positive (massive contango). They also do not track the underlying commodity price accurately over a number of years.

This can be shown very clearly when comparing two ETFs that track the oil price using futures – USO and USL. Although both ETFs use futures, USO typically tracks only the daily changes in the near month oil future. USL tries to track the daily changes in the near month to 11 months out (from the near month). That is the average price for all futures contracts in the next year, not just the next month. Since the oil price is often in contango, USL will track it much closer than USO. The following chart shows the huge difference in performance, that can be clearly seen around April 2020 during the “negative oil” futures incident (USO is blue and USL is yellow):

Understanding the futures curve shape and the average duration of the futures held inside an ETF is important before placing a trade.

Trading Position

Options that have over 1 year to expiration are called Long-term equity anticipation securities. They are often abbreviated to “LEAP call” (for calls), “LEAP put” (for puts) or “LEAPS”(for any option either calls or puts). UNG OTM LEAP calls cost a relatively small amount, but can control large position sizes. Depending on how far OTM there is a higher probability (say 60% to 75%) that they lost value slowly over time. However they can only lose the entire premium paid for the position. But if natural gas spikes higher they can quickly go ITM and trade with much higher deltas. They therefore have a great asymmetric risk to reward profile, especially if started during low volatility. They are likely to fail, but if they win they can win big.

On trade entry by definition OTM leap calls will ultimately expire worthless more than half the time (if they were held all the way to expiration. This is because they have a delta of less than 50% on trade entry. When a LEAP call is losing money any residual value for the decaying option can reclaimed by selling at 50%. For example, if originally bought Jun 2022 $12 calls for $1.5 then could sell after it has decayed to $0.75 to maintain some value. Another approach is simply to position size appropriately for the portfolio and let it expire worthless (having already accepted the full risk as part of the portfolio). Alternatively can roll out in time to further six months if want to maintain the position. Our approach is normally to exit position and maintain some value if not working or roll out in time. Don’t normally let the LEAP go all the way to expiration.

To manage upside we would typically take some profit off the table at 100%, if reached in short order. For example, consider buying a LEAP more than 1 year away for $1, then after a price rally selling half for $2 two months later. This means a zero risk trade for remaining 10 months of the option lifetime. The position is now half sized, so will not make as much potential profit. However half sized position can now be allowed to run for many months to see how it does. Since this example position contains no risk it could be allowed to run almost to expiration to see how it does. Unless the calls are very deep ITM (low time value) should consider rolling or selling with 60 to 30 days to expiration to avoid option decay.

Implied Volatility

Paying attention to implied volatility (IV) on trade entry for LEAP calls is important to maintain trade value. Since LEAP calls are sensitive to increases in volatility, rising volatility can provide a trade profit even if the underlying does not move that much. The important IV measure is not just the absolute percentage (%) as “high” (e.g. 50%) or “low” (e.g. 10%). The measure used for trade entry is the percentage (%) relative to the recent IV historical trading range (usually 1 year). Ideally LEAP calls are bought when IV is towards the low end of its annual trading range. For example, assume an IV trading range for the previous of year of 9% to 20%. Buying when UNG IV is 10% would be buying at the bottom of the volatility range. Once the trade is on, looking at option vega will show how much the option would increase with a 1% move higher in volatility (all other variables being equal). It is quite possible to see a significant % profit in a LEAP call if volatility rises quickly. Importantly LEAPs trade on expectations for future volatility at option expiration not on for expectations for the next few days or months. Although short term and long term volatility are usually correlated they may not necessarily move with the same magnitude. A short term spike in IV may not move IV in longer dated LEAPs. For example, a natural gas supply crunch that will likely be resolved next month, may not move option pricing in 12 months because the market expects it to be resolved by then.

LEAP calls are not “buy and hold” trades and so do require monitoring and risk management. Holding the LEAP call only can be a valid strategy. However over the long term selling calls mechanically or dynamically can improve returns and risk management. Selling calls does limit the theoretical unlimited upside, but on average it improves and smooths out returns. Selling calls does not have to be done against the entire LEAP call position, so with some strategies the theoretical unlimited upside can be maintained.

Selling Calls Mechanically

Another form of risk management is selling calls against the long LEAP call. This can be done ATM to try and exit position, but still get some premiums for next month. Alternatively this can be a scaling out exit strategy, to sell OTM calls next month, 2 months and 3 months out. For example if UNG is at $12, sell the July calls at $13, Aug at $14 and Sept at $15. This should give similar option premiums for each call sold, but gives more time for trade to rise and different time frames to sell calls. There is no role on the amount of contracts to sell, and it doesn’t have to match the long LEAP calls contract. For example if already own 100 LEAP calls, could sell 40 calls in July, 30 calls in Aug and 30 calls in Sept.

Alternatively if would like to exit half position can sell 50 next month ATM, leave the rest of the 50 contracts open. This gives the richest ATM premium that gets kept if position sells off. However if half the position gets called away in the next month cycle, then this still maintains half the position for further unlimited upside (no sold calls to cap the upside).

Repeating this monthly call selling strategies several times a year can help pay for the entire LEAP call. For example selling 10 calls ATM for $0.30 in six separate trades over 1 year would pay for buying a 20 LEAP calls at $0.90. This is a somewhat idealized example, because it assumes that the sold calls expire worthless each time. More realistic is to assume that half of the sold call premium is captured, so calls sold through out the year for $0.30 can on average to bought back for $0.15. This scenario is more realistic because it covers many call selling trading outcomes each month. For example selling 10 calls ATM for $0.30 in 12 separate trades could have multiple exit scenarios – some calls could expire worthless (full $0.30 gain) or need rolling into next month (e.g. buy back for $0.70 with $0.40 loss, then resell next month at $0.30). Taking loses on the sold calls still allows the position to make money, because the long LEAP call also increases in the rising market. However if the market rises too fast then sold calls could be hard to roll, so would be better just to exit the entire position.

Selling Calls Dynamically

Another more opportunistic strategy is to wait until IV increases during the year. This becomes more likely if the position was entered in relatively low volatility. When IV spikes up start selling “junk” options that are say 25% OTM. Depending on the level of the volatility spike these can be sold for between $0.10 and $0.25. Selling junk options for less than $0.10 is not recommended because commissions are a greater % of the trade. Also in a volatile market options that are way OTM but closer to zero (in the range $0.01 to $0.10) don’t decay that fast until very close to expiration – because there is always the underlying “threat” of a price spike.

Occasionally the commodity market presents some incredible premium on OTM options. For example on SLV in March 2021 during the Reddit meme stock volatility spike the IV doubled in a week from around 35% to briefly over 70%. During that week sold several SLV call options way over $0.10 that would normally have near zero value. Their volatility was implying a more than 100% move in silver by expiration in less than 60 days. Of course the options ultimately expired worthless, but also the premium got crushed within a couple of days after the high volatility mean reverted (see chart).

SLV Feb 2021 Implied Volatility spike

High IV in call options tends to revert back to a the mean value, which means that on average it doesn’t typically stay elevated for long periods of time – so was a quick return on investment. This mean reversion is why on average call selling works in higher volatility. Importantly having a long LEAP call covers when the underlying moves outside of the average price range – that is when the sold calls go way in the money at expiration. In the above SLV example, the call selling was always covered (not “naked”) because it was done against a SLV LEAP call that was already owned earlier in the year (and established in lower volatility). Admittedly this is one of the most extreme example from a commodity ETF in the last few years. However consistently selling the “junk” options to compliment a fully covered LEAP call position, can make regular income and still keep the long commodity trade idea alive. There is always the possibility of being “called away” on a huge market rally, but that would be a happy occurrence because the LEAP call would have greatly benefited.

Selling Calls for Hedging

One word of warning on dynamic call selling is don’t sell calls that are at or beneath the LEAP call strike. When beginning a trading position that will sell calls, it is better to sell way futher OTM or not bother selling any calls initially. Sell calls over time is to reduce cost basis in trade – in this case reduce the amount paid for the LEAP call. If that uncertain on amount at risk when starting a new position, then simply trade a smaller position size – don’t over hedge to start with.

When trying to rescue a position where the LEAP call has lost money, do not sell strikes in the near month below the LEAP call strike. This is sometimes called an “inversion” position. This position can potentially lose money if the commodity price increases, which the opposite of the original trade idea. This is because if the near term short option goes significantly ITM it will start acting like short stock – with a delta that trends towards negative one hundred (-100). The negative delta on the short call will be greater than the positive delta on the LEAP call (likely in the range of 50 to 70 delta). Therefore the entire position becomes net short. For example, 70 delta (from LEAP call) minus 90 delta (from deep ITM short call) is minus 30 delta (short position). These deltas are realistic examples for what would happen if the commodity rallied 20% with this “inversion” position (short strike call lower than long strike call).

Short calls are great to generate income or exit a winning trade. however when selling calls only to reduce long deltas (i.e. reduce risk) it is probably better just to sell (to close) some long LEAP call contracts. Selling calls should always be a compliment to main LEAP call position, not exclusively for reducing risk by adding short positions to a long position (hedging). Sometimes the best risk management is just to sell underlying position, not try and over hedge with calls. If the concern is losing all the LEAP call premium, then the position size is probably too large for the portfolio.

Portfolio Strategy

Importantly however the slower time decay of this strategy allows holding the entire position through a downdraft, because there is time to recover the loss. No action is required with correct portfolio position sizing, because the risk is accepted on trade entry. The position size can be 1% to 2% of the portfolio for a “normal” trade, or up 5% for a high conviction position trade. In previous trading experience we found that these LEAP call strategy should not be sized over 5%. This is because the position is still all time value and as such is decaying every day (even though daily decay is small). Additionally the combination of strategies in a portfolio is very important. Should not have an entire portfolio of OTM LEAPs as strategy for all portfolio positions. For example, having 20 distinct LEAP calls each with a position size of 5% would be have unmanageable theta (time) decay. Essentially an entire portfolio of LEAPs would have be 100% time value with no intrinsic value. If running LEAP strategies on a few underlying ETFs, then other portfolio positions should be in short volatility strategies (e.g. credit spreads) to compensate for the daily theta decay.

Trading Update

Trade entry was to go long natural gas in 2021. In March 2021, bought the UNG Jan 2022 LEAP call (10 months out) for $0.94. A few weeks later UNG went down to around $9, and the LEAP was losing money. However there has been a nice rally into July 2021. When UNG pulled back from peak around $13 to about $12.60, exited half the position in case this was the “big one” for a pull back. Natural gas is hard to trade because spike up quickly with a nice profit, then be back to break even 2 weeks later. Obviously as soon as the position is halved, the market rallies – but that’s just trading. Some physiological experience trading cryptos is helpful, because the UNG short term trading peaks and troughs can have similar severity (even though the fundamental drivers are obviously massively different).

UNG Year to date 2021 price chart – including trade updates

To get some extra juice in the trade, sold the $15 Aug 2021 calls for $0.20 against the entire position. The high premium for selling a 15% OTM call option was possible due to high IV. This trade is to tempt the market to try and hit a $15 target in only a few weeks, but also to hedge a pull back.

However as the market rallied again past $13 a couple of days later, realized that had made a mistake on being the start of a big sell off. Therefore was looking keep the long position for potentially higher than $15. This may seem like flipping ideas and being too wishy washy. However UNG looks more bullish then expected and resistance at $13 disappeared quickly. Basically would like to maintain a larger position size, but would like to have finger on the exit button. Also since had just made a nice profit selling half the underlying LEAP, we had the “house money” to do another long trade. So in order to maintain long deltas, bought the $15 Sept 2021 calls for $0.42. This made a calendar spread in the $15 Aug/Sept pair for total cost of $0.22. The calendar spread is in addition to the now half position sized underlying LEAP call Jan 2022 $11.

Trading Summary

This was an overview of how to use LEAP calls and short call overlays to trade commodity ETFs. The aim was to maintain a position, take risk off on the way up, and lighten up towards the end of the trend. Another trading update should be done when the current natural gas position is significantly changed or exited.

Uranium Position Trade

In 2020 and early 2021 we have started what will hopefully be a multi year position trade in uranium stocks. A position trade is taking a significant portfolio % trade (up to 10%) on a high conviction trade idea, to hold for several months until the fundamental trend peaks. Commodity trading is notoriously hard to time, because often there are several years in the wilderness, followed by huge peaks in a few months or years, following by equally rapid declines. Therefore some level of trend following is required to avoid having capital tied up unproductively for years.

Trading Products

The uranium sector is relatively niche compared to commodity sectors like oil, natural gas or gold. Historically the uranium sector has been underserved by ETF products, and there are currently only three URA, URNM and NLR. Both URA and URNM are more direct play on the uranium commodity producers, versus NLR that also includes nuclear power related stocks.

NLR will be ignored for this position trade, because it focuses on nuclear industry conglomerates, utilities and only some uranium miners. It trades more like large cap equity and only requires that companies get 50% of their revenue from uranium sector.

URA has been in existence since 2010 and focuses on large and medium cap uranium producers. URNM started trading in Dec 2019 and seems to have been constructed to only allow strict uranium producers. However to achieve this allocation URNM has to hold significantly smaller cap uranium producers and penny stocks that might not make it into other ETFs. For example the 4th highest URNM holding Yellow Cake PLC only has a market cap of $400 million, and with a 8.9% allocation. This makes URNM a more pure play on uranium but will definitely make it more volatile. Some holdings that have less than 5% allocations are penny stocks and will trade accordingly (high peaks, low troughs etc). The URNM ETF allocation is ideal for Uranium producer exposure in one place, but need to understand what it contains and don’t be surprised if it moves very quickly up or down.

This is direct comparison of URA and URNM top ten holdings. 47% of URA is in the top 2 main sector heavyweight stocks, but for URNM this is only around 32%. The URNM holdings are less concentrated in the larger cap firms. URA and URNM also trades LEAP options but they seem to have wide bid/ask spreads, so it appears more efficient to trade the ETF directly.

Credit: etf.com ETF compare tool

Cameco (CCJ) is the major North American uranium producer. CCJ is widely covered in research in US and Canada and and is often used as a proxy for the uranium sector. In late 2020 and through out 2021 the sector has broken out above previous multi year resistance. The following chart compares 5 years of historical price performance for ETFs URNM, URA & NLR with Cameco (CCJ) stock. During the last 5 years URNM was listed in Dec 2019 but all others were already trading at least 5 years ago. The relative outperformance of URNM is due to it’s mix of pure uranium producers including penny stocks.

5 year historical performance for 3 Uranium ETFs and 1 major producer.

Completely separately there are actually CME traded Uranium futures but they appear very illiquid and don’t have any option liquidity. Logically futures would seem to be a good way to access the physical uranium market, but they seem to be not be actively traded in any time frame (from near month to one year out). Have not researched why this should be, because many other commodities actively trade on CME futures. Whatever the reason, uranium futures are not useful as a trading vehicle. Anyway if the commodity price increases then uranium producers equity should provide more upside leverage than physical uranium.

Uranium Worldwide

Uranium production takes place in many countries around the world, but has significant concentration in only a few countries. More than half of all identified uranium resources are from only 3 countries. Recoverable “identified resources” means reasonably assured Uranium resources in the ground, plus inferred resources from mine surveys. The following pie chart breakdowns the worldwide percentage of identified uranium resources by country:

Credit: Pie chart was generated in house using raw data from world-nuclear.org

Traditionally a commodity producing countries Australia have more than a quarter (28%) of world identified uranium resources. However less expected countries like Kazakhstan have major mines and account for 15% of uranium resources. Canada makes up rest of the top 3 countries with 9%. Many other countries make up the remaining half of uranium resources but always in decreasing percentages. The USA only accounts for 1% of world identified uranium resources.

New Uranium Trust

One very significant event in 2021 is the planned US listing by Sprott Asset Management of a new investment trust to own physical uranium. The uranium price has been accessible for 5 years in Canada on the Toronto exchange as Uranium Participation Corporation (TSX: U). However crucially Sprott’s plan is to buy UPC out and change the investment structure to allow a US listing – which will open it up to many investors portfolios.

Quoting mining-journal.com (with our italics) : “Industry commentators have suggested that Sprott’s market participation has the potential to transform uranium from a sleepy commodity whose consumers dip into an opaque spot market to supplement their long-term contracts, to a more liquid, transparent and easily investable sector for investors who want exposure to a commodity expected to face increasing demand.”

Sprott has already brought gold (PHYS) and silver (PSLV) to market, so has a good track record in the resource space. The current listing date for new Sprott uranium trust is July 19th 2021.

Uranium doesn’t traditionally have speculative investor demand in the same way as commodities like oil and gold. The spot uranium was historically hard to buy as an institutional or retail investor – either with futures or via a physical trust. Having US listed spot uranium trust could provide organic investment demand as an alternative asset diversifier. There is a large pool of investor funds sloshing around the world looking for returns, so it could land on uranium in the next few years.

The other important item with uranium companies is the relatively small market capitalization of the entire sector. The uranium sector’s current market capitalization is about $30 billion. Any significant in flows into uranium equities could result in this rising significantly. The combination of a new physical trust and equity in flows could translate into wider investor interest in the uranium sector.

Trading Update

The original URNM trade entry was in April 2020 on the rebound from the post covid crash, after the market had decided the world wasn’t ending. The URNM position trade strategy was simply long ETF with no options involved. The ETF spread was relatively wide, so trade entry required working some limit orders to get a decent price – but often URNM would still only fill very close to the ask. e.g. if the bid/ask from $27.65 / $28.00 would only fill at $27.95 even by walking up Buy limit orders in $0.01 increments. URNM is too illiquid to trade regularly.

In Jan 2021 the position was doing well (up about 57%), but did not believe that our position size was big enough for the trade conviction. One thing that we had noticed when analyzing trades from last 2 years (including 2019 and 2020 trades) is that generally not getting paid enough for being right – usually because the position sizing was too small for the portfolio. There were also around 20 to 30 distinct ideas and strategies that were not contributing enough to the bottom line. Decision was made to focus on only 10 to 15 ideas at a time for the trading account, which allows idea quality to improve. This also reduced the time monitoring active positions with the constraints of the day job. When getting significant macro calls correct we are attempting to increase size in 2021 to maximize returns. For example with “long oil in 2021” sometimes the “normal” position sizing was increased from 10 contracts up to 30 contracts. It’s a bit out of the comfort zone because the position sizes are 1 or 2 times bigger. However since we always maintain good risk management – the good calls are still beating the losers so far.

In the spirit of getting out the comfort zone on major trade ideas we decided to pyramid up with 2 extra purchases around $44 each in Jan 2021 to bring up with average price to $39. There was fairly clearly some institutional buying in the last couple of months of 2020. So although adding in Jan 2021 was late after the 30% run up, it appeared we were in good company. Having the initial position from April 2020 allowed us to enter a very bullish trend at full position risk, but still have a 10% downside cushion down to the new average price. The following chart shows where the greater risk was added and how the average purchase price moved up.

Summary

This URNM position trade also shows the importance of having some position in trade ideas you care about. Then you will care enough to monitor the position and not miss opportunities to add size. It can be hard to take a brand new position trade in a strongly bullish trending market – even if the trade conviction is high. This trade will be held long term in an IRA and potentially be a multi year hold.

Long Energy in 2021

This outlines the investment thesis for starting and maintaining our long energy position in 2021. This is then followed by implementation of the short selling put strategy on XLE energy sector ETF. Selling XLE puts has been an effective strategy in the first half of 2021, however the year started with quite a bit of uncertainty in energy sector. Fortunately the uncertainty provided “fear” in the option premiums, so running a strategy that benefits from high volatility makes sense. Also covered is why some potential XLE trading strategies were rejected due to the higher volatility.

Pricing note: Unless otherwise stated XLE prices are weekly closing prices, not daily close or extreme high/lows intraday.

Investment Thesis

In the previous year 2020 there had already been one huge XLE sell off into the Covid crisis low, which was ultimately hit at $25.86 on 20th March 2020.
Then followed by a 5th June peak around $44.84 within 2.5 months. This was then followed with a steady fall back to $28.72 on 30th Oct 2020.
The year 2020 ended with a very steep 32% rally in the last two months, ultimately ending at $37.90 on 31st Dec 2020. XLE was trending bullish or bearish in either direction for a few months, but then would reverse direction and trend in the opposite way for a few months. This meant that the energy outlook was somewhat uncertain – specifically investors were taken by surprise with Oct 2020 nearly revisiting the March covid low. This 5 year chart shows the context:

On a multi decade chart XLE is also at the bottom of the trading range. The main bearish case for oil producers in the energy sector is that fossil fuels are a dying industry that is destined to be replaced by alternative energy such as wind or solar. This maybe true on a 10 to 20 year time horizon looking towards 2030 and 2040. However energy is cheaper enough on an absolute basis to take a tradable medium term 2 to 5 years position. XLE is trading at the same price as 15 years ago – obviously XLE has paid significant dividends since 2005 so that isn’t a zero percent return – but it is clearly “cheap” based on historical pricing.

Obviously looking at price only does not necessarily make a sector relative good value, so looking at historical price to earnings ratio is another well used metric. One such price to earnings ratio is the Cyclically Adjusted Price-to-Earnings or CAPE for short. CAPE is defined as a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. Looking at the energy sector CAPE shows relatively cheap valuation in 2020 with two annual reading of around 11 (18.42), rebounding to 18.42 as of first half of 2021. This is significantly cheaper than all other S&P sectors in the table below.

Also the percentage of energy sector in the S&P 500 is 2.53% as of July 2020. This will have increased in 2021 due to energy sector rally, but the percentage size compared to other sectors is still historically low. This reflects the energy sector issues, but is small enough allocation that if only some investor capital flows back into energy the sector could grow quickly. This is not an argument for it returning to 20% of the S & P 500 – only that an investor sentiment could see it rally quickly because it’s absolute base is relatively low.

For the full sector chart with all sector percentages – see visual capitalist .

Trading Strategy

All of this historical bearish price action did generate some good option premiums to sell into 2021. Even though XLE has been rallying in 2021, volatility has been high due to the constant threat of a significant sell off.

For other trading positions we’d often use deep in the money LEAP calls and selling shorter term calls to start a new position. That trading strategy often works best on growth stocks or commodities with zero dividends. However XLE isn’t currently a great candidate for that because of the dividend yield, and higher volatility on the long term LEAP calls. Other option trading considerations come into play with higher dividend stocks like XLE – stocks that don’t pay dividends have less chance of having ITM short calls being exercised on you as the contract owner takes the stock to capture dividends. Also overpaying for longer term LEAP calls in high volatility can be a problem if they were purchased with a lot of time value. Generally it is better to start the deep in the money LEAP and overwriting when volatility is lower. XLE isn’t currently a great candidate for that because of the dividend yield, and higher volatility on the long term LEAP calls.

Due the significant sell off XLE had a dividend in 2020 that moved around in the 4% to 5% range depending on price extremes – so buying the stock outright or selling puts to capture the dividend looked like a good approach. Since the energy sector was in play so much, put option premiums generate some significant put premium volatility. Given the combination of high volatility and excellent dividends, selling put options seemed like the best choice. See this historical volatility chart for the trailing 12 months from July 2020 to July 2021, showing the significant volatility spikes in first half of 2021:

It’s hard to time perfectly, but selling puts should generate monthly premium, and worse case secure a stock position in high dividend stock. The risk of selling puts at lower prices (on stock that you want to own long term) is that XLE runs away to the upside too fast, and the opportunity to own stock at a good yield is gone. Ideally would like avoid XLE running away to the upside and having to chase the market to “avoid missing out”. The ideal market for selling puts is one with a bullish or flat bias, with high option premium. Over a number of months, this is a balancing act to sell without the probability of being assigned. Part of the art is to sell options at higher and higher strikes every month, but not so high that when the market reverses at the top all profit is given back on one “bad” put. Selling put with XLE in the range of $40 to $48 out 45 to 60 days to expiration was done in early months of 2021 – but as the market went over $50 the strategy reverted to longer dated 90 day options at strikes in the $45 to $48 range. No put option was ever sold over $48 even though the market went as high as $55.

The red lines on the chart below show where the puts were sold. The start of a line is an opening position (sell to open), the end of a line is a closing position (buy to close) and the price level of the line gives the $ strike. Shorter lines indicate holding periods of 30 to 45 days, and longer lines indicate 60 to 90 days.

Each red line is trade of 10 contracts. Sometimes the risk was tripled up, with a maximum risk of 3 x 10 contracts = 30 contracts. During April 2021 there was theoretically a risk of ($45 x 10 contracts) + ($46 x 10 contracts) ($48 x 10 contracts) of about $139k (minus put premiums sold).However this was only done in rising markets when the older puts were nearly worthless. There was a theoretical risk of 30 contracts, but looking at probabilities the $45 and $46 strikes only had a delta of less than 10 (so had a greater than 90% of expiring out of the money). Also if the market suddenly turned very quickly they could simply be bought back to reduce risk. If there was a flash crash (e.g. a daily move from $50 to $40) then all 30 contracts would have gone in the money – but that volatility was unlikely according to the options pricing. A flash crash “could” have happened but it seemed worth the risk, as it was a very low probability event and the trade was working.

Although at the end of April the final put did get closer to assignment and the market was now trending down. Therefore made the trading decision to go back to 10 contracts only (1 red line) and keep further out of the money. There were still some decent premiums to be had into May because of the increased volatility. As XLE moved higher into May and June moved some of the strikes up because the market was trending upwards, and was ok to double up contract exposure (have 2 red lines or 20 open contracts).

Ended up taking on more risk in a bullish market while the XLE trend was up, but pulling back contract size when XLE was moving down (due to rapid sell off risk). Importantly “risk” here is a relative concept compared to buying XLE outright. Most puts were sold with a 35 delta or lower – which means that on trade entry they have about a 2 in 3 chance (65% or higher) of expiring worthless (making money) at expiration. So they mathematically have an edge of winning each trade, and can typically tolerate at least a $2 to $3 XLE pullback without losing. There is risk here, but XLE has to surprise rapidly on the downside and there are adjustments that could be made should that happen. Worse case end up with a dividend paying stock at a reduce price.

The selling puts trading strategy does have issues if XLE is chased higher and puts are just sold mechanically without regard for price in low volatility. Option volatility tends to decrease in rising markets, so selling near month options at the top of multi month uptrend is not ideal. For example, selling shorter term 45 day to expiration put options at $55 on a market that has just gone from $45 to $55 in a month can be asking for trouble. If that option is sold in lower volatility for $1 but has to be bought back at $4 in the higher volatility of a declining market – then that is $3 of lost premiums. That could be giving back 3 months of premium profits in a few days. It’s not “free” money, it’s money for taking risk and always need to respect the market’s ability to reverse. Market tend to reverse faster than they increase (“stock take the stairs up, but the elevator down”) – which is why the short put premium exists in the first place. Or those who prefer a more dramatic interpretation from the 1800s can always quote “He who sells what isn’t his’n, Must buy it back or go to prison”. Technically short puts are cash secured, but the short selling warning still stands – selling more put contracts than you can cover can be painful.

Margin Requirements

The short put strategy can require keeping the entire cash amount available to cover the short put liability (should the stock be “put” on a price decline). In accounts such as an IRA that require a cash secured put the full amount of cash needs to be available. In a margin account you are still liable to buy the stock back – for example consider 10 short put contracts on XLE at $40 strike that expires in 45 days. If XLE went to $0 (zero) in 45 days you would be required to buy $40k stock. However a broker typically only requires about $8k to $10k margin for a 10 contract short put option in the price ranges of $40 to $50 – even though the theoretical value of the stock position is in the $40k to $50k. The exact margin calculation requirements will move daily with strike price and stock volatility. The return on margin is a fantastic investment return if run successfully each month e.g. For 10 short puts assume $10k margin to sell a $1 option held for 45 days. Assuming $1 option profit every time, and run it about 8 times a year (365 calendar days / 45 calendar day option holding period) and then dividing by the same $10k margin used every time = about 81% annual return on margin. Note that % annual return is theoretical maximum return assuming all puts expired worthless – achieving half of that would be an excellent trading year.

Trading Summary

In summary, selling XLE puts has worked well for last 7 months and using margin can help juice returns. The strategy worked well because XLE went up or sideways and energy markets still had high volatility. However it is important to manage the risk and respect the power of the market by not fighting significant down moves. Recognizing down trends and adjusting position size to reduce risk are important for selling puts. The current plan is to maintain this working trade for the rest of 2021, but could re-evaluate anytime.

Credits: Oilfield Pump (Texas) image used at the top of this page was created by Jcutrer photos. All other credits are referenced inline.

Long Gold calls into 2023

Despite threatening to breakout to new highs in August 2020, the gold price in July 2021 is actually about the same as one year previous in July 2020.

While the Gold price has moved around in a range for the last year, the volatility in the Gold market has been steadily declining this year. This steady decline in volatility is arguably surprising given all the macro economic fallout from the Covid stimulus and other economic measures. However the Gold market appears to be predicting less pronounced moves, at least in the short to medium term.

Since there is low gold volatility we can take more time premium risk than usual and keep the call strike relatively close to the money. Using deep in the money call options is a favorite strategy to get leverage to an underlying without taking the same principal risk as long stock. Buying in the money call options typically means that the majority of the option premium is intrinsic value (“real” value not time value). However the time value of an ITM call option can still be much cheaper when the underlying volatility is low. The spread will also benefit if Gold volatility increases during trade, which is a possibility given volatility tends to be mean reverting.

Gold LEAP diagonal spread

Therefore we can take advantage some of the lowest gold volatility this year, and buy a very long dated LEAP call for Jan 2023 (with a 66 delta). Buying 10 GLD options is approximately the same size as a single call option on a /GC futures contract (obviously assuming similar strikes and expiration dates).

To try and pay for some commissions on the larger trade and get a small amount of income, the shorted dated Sept 2021 $190 call option will be sold (7 delta). This option has a 93% chance of expiring worthless at Sept expiration (100 delta minus 7 delta). But also a 14% chance of being touched between now and expiration (“double the delta”). Using the shorter dated short call does chip away at the cost basis every month. However it does mean that would likely have to roll and re-evaluate position if GLD price shoots up more than 10% in a couple of months – from todays close price $171 to $190 in September.

As of close on July 14th this gives the spread a long delta of approximately 58 delta. The long dollar amount for 10 contracts gives about $99,180 equivalent gold exposure (specifically $171.04 GLD price x 1000 shares x 0.58 spread delta). The long call Jan 2023 call is $19.85 and the short Sept 2021 call was $0.42, giving a maximum risk is $19,430 until Jan 2023 in approximately 18 months time. The maximum risk amount is calculated by (long 10 contracts x 100 x $19.85) + (short -10 contracts x 100 x $0.42) = $19,850 – $420 = $19,430. However there is plenty of time to adjust between now and Jan 2023, so the likelihood of realizing the full loss is low.

Trade Date
Category
Trans Type
Description
Symbol
Quantity
Price
Amount
14-Jul-2021
Portfolio
Sell to Open Short Call
Call GLD 190.00  EXP 17-Sept-2021
GLD210917C190
-10.0
0.42
$420.00
14-Jul-2021
Portfolio
Buy to Open Long Call
Call GLD 160.00  EXP 20-Jan-2023
GLD210120C160
10.0
19.85
-$19,850.00
TOTAL
$ 19,430

Importantly if GLD goes over $180 the Jan 2023 $160 will over its breakeven price, and will begin to trade more like an underlying stock position as the option delta moves towards 100. The call option leverage allows paying less than $20k to control a $100k gold position. The long dated call also reduces the risk in a protracted gold sell off. Giving time to adjust and roll as conditions warrant (e.g. higher volatility) or gold price opinion changes (e.g. gold price declines and would like to exit to maintain some option value for other trades).

In summary this is a leveraged gold long position as a portfolio "hedge" to avoid "missing out" on a run away gold price. It gives plenty of time for the idea to play out. Additionally the capital efficiency of LEAP calls manages the downside risk, but gives a significant upside potential if Gold moves up in next 18 months.

Bitcoin Fund Portfolio Rebalancing

This trade adjustment on European based Bitcoin fund SE:BITCOIN.XBT describes reducing bitcoin exposure inside a “speculative” trading IRA. The main reasons for selling the bitcoin fund are portfolio rebalancing, mitigating long term provider risk and high product expense fees.

Portfolio Rebalancing

This trade has been a multi year Bitcoin long, trading two Bitcoin tracker fund products GBTC and SE:BITCOIN.XBT. Both funds aim to track the Bitcoin price (BTC), and own a claim on underlying Bitcoin. For brevity the underlying Bitcoin owned by either fund will be referred to as the Net Asset Value (“NAV”). As a quick review GBTC is Grayscale’s well known investment trust whose price is tied to Bitcoin. The initial GBTC position was originally purchased in March 2017 with BTC at $1,250 – see initial trade entry for more background.

However in 2018 due to GBTC having a very high premium to the actual underlying bitcoin holdings (NAV), it became very unattractive as a long term holding. Therefore the entire GBTC position was replaced with a more obscure Bitcoin fund SE:BITCOIN.XBT traded in Swedish Krona on the Swedish stock exchange. The fund historically tracks the Bitcoin price much more accurately than GBTC with only a nominal premium to NAV. Bloomberg has average 52 week trailing NAV of -0.12% for SE:BITCOIN.XBT, but a whooping 18.22% for GBTC (as of Feb 4th 2021). Incredibly around year end 2017 and into 2018 the average 52 week trailing NAV premium was 53% for GBTC (on 16th Feb 2018) and occasionally spiked over 90%

GBTC was sold in Feb 2018 due to this huge premium to NAV – see the original trade exit for a detailed discussion. The final sale value contained NAV (the equivalent amount of Bitcoin held by the fund) and the premium (that the market assigned over fair market value for the Bitcoin held in the fund). The NAV amount was then reinvested into crypto with approximately two thirds in Bitcoin (SE:BITCOIN.XBT) and one third in Ethereum (SE:ETHEREUM.XBT). That maintained exactly the same amount of crypto holdings, but with some crypto diversification and greatly reduced exposure to fund premium. The premium part of the sale was “taking money off the table” and was invested into other portfolio assets. This crypto rebalancing trade was done at approximately BTC $10,025. All these trades were IRA eligible so rebalancing was not a taxable event. Rebalancing these XBT funds frequently would not be advised because of the wide trading spreads and international transaction fees. 

Fast forward 3 years to Jan 2021. Crypto prices have gone through a huge decline (a “crypto winter”) from about Dec 2017 to Dec 2018 – with BTC ultimately reaching a low of $3,300 around Dec 2018. Then came the recovery rally from Dec 2018 to Sept 2020 with BTC reclaiming $10,000. Following that Bitcoin has been on a rocket ship launch starting in Oct 2020 at approximately $10,600 about to a high in early Jan 2021 of $40,405. The latest boom is claimed to be institutional money buying in large tranches, chasing exposure for themselves or their clients.

In Feb 2018 felt like we hung around at the party too long, with BTC moving from a peak around $20,000 in Dec 2017 down to our rebalancing trade at $10,025. Were actually saved somewhat by being able to the capture the GBTC premium. So this time we decided to see if we can improve by selling near the top of a huge peak, not waiting for post peak decline (speculation of course). Therefore during decline from high in early Jan 2021, exited two thirds of Bitcoin SE:BITCOIN.XBT position on 20th Jan when BTC was approximately $35,105 (about 13% from peak a few days earlier).

Ethereum (SE:ETHEREUM.XBT) position was maintained with no reallocation. Even after allocation the speculative IRA portfolio still has 25% crypto exposure, of which approximately 60% is Bitcoin and 40% Ethereum. 

Provider Risk and Fees

Any crypto exchange traded product (such as GBTC or SE:BITCOIN.XBT) has some significant counterparty risk if held for several years. Fund could get hacked, the provider may lose private keys or have some other internal company disaster that impacts the underlying crypto holdings. There is also significant provider discretion about how to handle hard forks and how (or whether) they accrue that value back to fund holders. Bluntly there is a constant tail risk that one day investors lose some or all of their investment in a crypto fund (potentially overnight with no warning). Ironically holding these crypto funds puts a single point of failure back on to the provider – that the underlying crypto “trustless” philosophy was supposed to resolve.

Both crypto funds have very high management fees that mimic hedge fund style management fees. GBTC has 2.0% management fee (but higher NAV premium) and SE:BITCOIN.XBT management fee 2.5% (0.5% higher, but less NAV premium). Although crypto funds may be able to justify high fees due to the very specialized product, this has to be a long term holding concern – especially given industry trend towards much lower fees. As any crypto fund position size grows, the management fee becomes much more expensive annually in absolute real $ amounts. Investor alternatives to paying crypto funds management fees are managing their own crypto keys in cold storage. Cold storage approach has no management fee, but requires investor have a detailed crypto knowledge of potential multiple cryptos. An investor needs to balance no management fee in cold storage, with the possibility losing their investment due to their own mismanagement. Therefore the fund management fee is an expensive convenience fee to trade crypto on exchange, manage crypto in cold storage and implement security protocols.  

Investors can currently ignore high fees because crypto is currently trading on Fear Of Missing Out (FOMO) momentum – who cares about 2.5% fees when you make 300% plus per year? However through down markets over years or months, the fees begins chip away at long term value. The Nerdwallet Mutual Fund calculator can be used to compares product fees for an initial $10,000 investment in the (clearly hypothetical!) scenario where BTC price is static. Example shows that with no BTC price appreciation simply holding SE:BITCOIN.XBT with its 2.5% management fees loses nearly 12% in fees over 5 years – just for holding.

This clearly shows the impact of high management fees on long term holdings – these funds can only be held if high confidence crypto will rise. However as a medium term trading vehicle for crypto exposure with no taxable gains in an IRA, it is well worth these risks. Just remember to periodically take some off the table to mitigate the provider and management fee risks. 

Summary

GBTC and SE:BITCOIN.XBT products are a good trading proxies for crypto, but are still third party representations of a “promise to pay”. If you don’t have your own private keys, you don’t truly own your crypto. Crypto funds should not be relied on for multiple year long term buy and hold crypto exposure. Only crypto in cold storage does that. 

The crypto asset class is incredibly hard to hold without taking at least some money off the table on the highs. The peak to trough declines were about 85% for BTC and 94% for ETH from Dec 2017 peak to Dec 2018 trough. Unless some house money was already taken off the table in Feb 2018, it is doubtful that would have held all the way through “crypto winter” without finding the need to “do something”.

There is a reasonable chance that BTC goes significantly higher – however there are better asset classes that are less frothy starting from a lower base. BTC can potentially move from $35,000 to $100,000 from high (e.g. 200% return) but there are better opportunities to redeploy some of that crypto capital. Selling some for portfolio allocation is not the same as being bearish on crypto. This speculative IRA portfolio still has 25% crypto exposure, because it is the gift that keeps on giving. However if/when the crypto music stops, we will have made enough to construct an entire new portfolio from one single original Bitcoin position – whatever happens to BTC in future.

 

Emerging Markets Iron Condor

This is another bread and butter trade with an emerging markets iron condor, going out a bit further in time to October with 78 days to expiration (DTE). Emerging Markets ETF EEM has sold off rapidly due to market tariff and rate cut talk this week, which has provided inflated volatiliy. This is a limited risk range bound trade for EEM with the expectation that the market maintains its position over the next two months and that volatility contracts.

Trade entry Emerging Markets Iron Condor

Here is the trade entry for EEM iron condor:

Contracts  Expiry Date  Strike   Price   Amount   Trade
-------------------------------------------------------------
+5         Oct 18 2019  45.00  C $0.05   $ 52.69  Buy to Open
-5         Oct 18 2019  42.00  C $0.74  -$372.25  Sell to Open
-5         Oct 18 2019  38.50  P $0.76  -$317.20  Sell to Open
+5         Oct 18 2019  35.50  P $0.35   $122.79  Buy to Open
-------------------------------------------------------------
Total    	                        -$513.97 (credit)

On trade entry on 2nd August there were 78 Days to expiration DTE through to option expiration on 18th Oct. According to the 30 day rule this means that can consider exiting the trade on or after 2nd Sept. On 2nd Sept this would still leave approximately 48 calendar DTE, so there is plenty of time to adjust or exit. The following table sounds the future trade lifecycle dates when trade exit or trade adjustments could be optionally applied:

Trade Lifecycle for EEM Iron Condor

Trade DateTrade Lifecycle (Optional)Days to Expiration
(DTE)
2nd August 2019Trade Entry - enter Iron Condor according to original trade above78
2nd September 2019(Trade Exit) - optional earliest possible date for a full trade exit according to 30 day rule.48 to 1
13th September 2019(Trade Adjustment) - latest possible date to do a trade adjustment using the same Oct options (trade adjustments must be at least 30 DTE)78 to 30
18th October 2019Trade Exit - latest possible date to exit original Iron Condor with any optional trade adjustments that were added.1
Note: Trade Lifecycle actions that are optional are in brackets like this (Trade Adjustment) or (Trade Exit).

The option deltas sold on each side are approximately 35% on the call and 25% on the put, so there is approximately a 70% chance that the call will be touched, and a 50% chance that the put will be touched anytime between now and Oct expiration. Therefore it is likely that the short options at $42 and $38.5 will be tested at some point on this trade, but it can be held due to the limited risk. The breakeven points of $43 and $37.5 are at the high and low ends respectively of the trading range price action for the last year, so we can be reasonably confident that at some point in the next couple of months EEM could return to the the middle of this range – even if there is likely to be some short term volatility, possibly with the short options being touched.

Trade Summary

The aim will be to close the trade for a $100 to $250 profit after 30 calendar days have elapsed, but this could require being patient and waiting for volatility to come in a bit and the trade to move back into the middle of the range around the $40 mark.

Mexican Bearish Put Butterfly

This trade idea is a trade adjustment to a currently open bearish trade on the Mexican Market ETF (EWW). The strategy ultimately converts the existing bearish diagonal spread into a bearish Put Butterfly.

Trade Update for 30 July 2019

A trading update on July 30, 2019 shows that the ETF has brought the speaking been in a range for the majority of the month around the $42 mark. However with the federal reserve rate cut announcement there was a drop off on the afternoon of 30 July that has caused for the ETF to move down beneath the $42 strike in August. This means that the August short put is now ITM and needs to be managed accordingly however this is being fully offset by the $43 port in the September cycle. The aim here would be to maintain the position slightly closer to expiration to allow any time premium to drain out of the August cycle, and then either close the position or do a short put roll into September.

The rolling options are to either roll the $40 put into either a $41 or lower put to maintain the bearish position into Sept 2019. Alternatively the put could be rolled to create a September butterfly by selling twice as many puts and adding a down side put for protection. This would create a butterfly that can be held into September expiration. Ideally this would be done into a higher volatility environment to get as much juice as possible into the September options.

Long Mexican EWW Bearish Put Diagonal Calendar Spread - Trade Update Chart - 20190731

The position has approximately $120 profit and long as the etf stays under the $42 level this profit is not at risk. The 30 day calendar period has elapsed so the position can be closed or adjusted anytime. Therefore position can be maintained for a few extra trading days and monitored for a good Time to roll into September once even more time value has drained out of the August short put. Currently there is still approximately $0.50 time value (or about $300) left in the August short put, so this is a potential time profit that can still be extracted from the position.
Ultimately no adjustment was done today.

Trade Update for 1 August 2019

On 1st August 2019 in afternoon trading the Trump administration announced more tariffs against China. This somewhat spooked the markets triggering a fairly swift sell off in markets especially those effected by tariffs. This meant that the August short put at $42 has gone significantly ITM. With Mexican ETF EWW trading at approximately $40.75 the put had only about $0.20 extrinsic value, so it was a good candidate for rolling.

The sell off generated increased volatility in a short amount of time and ATM put premium in September looks quite attractive to roll into. This was an opportunistic trade due to the swift selloff, so the decision was taken to convert the position to buy September butterfly.

The August $42 put was brought back (buy to close) for a $450.71 loss, and was replaced with 12 contracts of $41 puts sold to open in September, followed by 6 contracts of $39 puts bought to open. The existing $43 put in September was maintained and not changed as part of the position. This converted the entire position into a $43/$41/$39 September butterfly. The entire new position result in a $288.67 credit, so the most that can be lost on the trade is now -$450.71 (from the losing $42 august option roll) plus the $288.67 credit received for Sept butterfly – so max position risk is now only $162.04. This roll was all completed in one trade ticket with one set of commissions.

This table gives the new position below. The top two options rows are option roll described above. The last option row is not a new position, but simply maintaining the original long $43 put from the original trade entry.

 
Trade Date
Category
Trans Type
Description
Symbol
Quantity
Price
Amount
01-Aug-2019
Income
Buy to Open Long Put
Put  EWW  39.00 EXP 20-Sept-2019
EWW190920P39.0
6.0
0.66
-$393.35

01-Aug-2019
Income
Sell to Open Short Put
Put EWW  41.00 EXP 20-Sep-2019
EWW190920P41.0
-12.0
1.33
$1,596.32

01-Aug-2019
Income
Buy to Open Long Put
Put EWW  43.00 EXP 20-Sep-2019
EWW190920P43.0
6.0
1.52
-$914.30

TOTAL
-$288.67

 

This roll exchanged approximately $0.20 of time value in the August cycle for approximately $2.00 time value remaining in the September cycle. If there is a large move either way over for example $43 or $39 then the maximum amount will likely be lost. The optimum trade scenario would be to close around $41 at September expiration. Because the trade is a butterfly trade it will benefit from a decrease in volatility and from the waiting until expiration. Given the low risk in this trade it would be fine to wait until very close to September expiration. Even if Mexican ETF EWW moves around a lot there will likely not a significant profit/loss changes until closer to expiration.

Summary of Mexican bearish put diagonal spread (converted to butterfly)

The Mexican ETF EWW will likely be volatile over the next week or two and may well move outside the ideally trading range of $39 to $43. But the approximate $41 target for September is on the low-end of the historical trading range for the last six months (a historical support line) so it is possible that becomes resistance with a move down in August and subsequent rally back up in September. However the trade will be held and re-evaluated in 30 calendar days - basically a low risk trade waiting for lower volatility and getting closer to September expiration.

Trading Gold Long Term Diagonal Spreads

This trade idea shows how to approach trading gold with long term diagonal spreads. The trade example shows how a bullish multi month GLD long call diagonal spread was entered and managed. This trade was IRA eligible so using multiple option legs does not generate lots of complex tax reporting, and there was no issue of paying extra capital gains if the trade is ultimately successful.

Gold market and GLD volatility overview

In March 2019 FED was signaling a rate pause which could be bullish for gold prices. This is an example of using options to express a “long gold” opinion in a portfolio, in this case using the physical Gold precious metal ETF (GLD)

In March 2019 Gold volatility was approximately 9%, which was in the lower quartile (lowest 25%) for the last six months – having had a range of approximately 12% in Dec 2018, down to 8.5% in Feb 2019. Low volatility generally makes a better trade entry for long term calendar diagonal spreads. Importantly saying that “the volatility is cheap” only means relative to its own recent history in the last few months for this particular ETF or commodity. This does not mean that the underlying will not move around, because trading gold is historical volatile. This only means that the debit on trade entry is cheaper, simply as you don’t pay as much option time premium for the longer dated call (because the market is currently pricing less of an expected move by Sept 2019).
The chart below shows the GLD volatility chart for several months before and after trade entry on 22nd March 2019.

GLD July 2019 1 year volatility chart
trading gold - Long GLD Diagonal Calendar Spread - Volatility chart with Popup Balloon - 20190729

Trade Entry in March 2019

Having made a decision to long gold for 2019, the next step is to structure a suitable risk/reward trade within the 30 day rule. Here is the original trade entry when GLD closed at $123.97 on 22nd March 2019:

 
Trade Date
Category
Trans Type
Description
Symbol
Quantity
Price
Amount
22-Mar-2019
Portfolio
Sell to Open Short Call
Call GLD 128.00  EXP 17-May-2019
GLD190517C128
-6.0
0.77
$464.65

22-Mar-2019
Portfolio
Buy to Open Long Call
Call GLD 128.00  EXP 20-Sep-2019
GLD190920C128
6.0
2.70
-$1,622.29

TOTAL
$ 1157.64

 

This trade was OTM so had approximately a 30% of being ITM at expiration - it was therefore a lower probability trade, but high conviction portfolio position ("long gold for next 6 months"). Losing the entire trade premium (defined at trade entry) was acceptable risk for the overall portfolio - but the payoff was potentially large for the relatively small initial risk, so it created the right risk profile to express the trade idea. Initially selling the shorter dated call help finance the longer dated call, and reduce the overall risk in the position. The intent is to avoid this shorter call being assigned and roll it multiple times over the summer to gradually chip away at the premium paid for the longer dated call.

Here are the main high level scenarios for the trade outcome - GLD stays in a range, goes up a lot or goes down a lot (just about covered all scenarios in finance there!):

If gold stays the same or rallies slightly towards but not through the short call, it can likely be bought back for less than it was sold for - this helps to reduce the basis on the original longer dated option. If this can be done over a few months rolling option calls can nicely reduce the basis on the original longer dated option. Usually selling the 30 delta OTM call is a decent starting strategy initially, but once the position basis is reduced then selling calls that are more than 30 delta OTM is ok.

If gold rallies strongly in the next month, it maybe difficult to roll the short call at a profit. This is a risk of the calendar spread strategy - the market call is "right" but gold rallies too fast, and the position makes little money. This happens because the negative delta of the short call becomes similar to the positive delta of the longer dated call - so the overall position can become delta neutral or even negative delta (short underlying) in a strong rally. On average though the short call can be managed with month to month adjustments.

If gold tanks in the next month, it maybe difficult to roll the short call to get any reasonable premium in the same strike in the next month. However if any premium is available in the next month call, then it can be sold at the same strike. In the situation where gold goes down, one luxury of any calendar spread strategy is to simply sit on the trade and hope it comes back. This is "ok" as a strategy with calendar spreads because the limited risk was defined at order entry.

Trade Adjustment in May 2019

The trade adjustment that was chosen in the end, was to let short call expire worthless and simply hold the longer dated Sept 2019 call option. This has keeps the trade risk to approximately $1150 but there is still now no upside cap and still plenty of time for the trade thesis to play out. The trade is now $464 better off than if we had just bought the long dated call for $1622. Sometimes doing nothing can be the best option.

Option Skew in July 2019

As of 29th July, the Sept 2019 Option premiums are indicating that the market is pricing in significantly more upside than downside for gold in the next 7 weeks. Looking at the option chain below shows the distance of both 30 delta OTM put and call options from the underlying GLD price.
trading gold - Long GLD Diagonal Calendar Spread - Option Chain Skew Sept 2019 - 20190729

GLD is traded at $134.53 as of the NY close on 29th July 2019. Going 53 days to expiration on the Sept 2019 option chain, shows that the $139 call (with a delta of 0.2998) has approximately the same delta of the $132 put (with a delta of 0.2963). This means that market is assigning the 30% probability that GLD is $4.50 higher by Sept 20th 2019 expiration and a 30% probability that is $2.50 lower. That appears to be a huge bullish skew indicating that the market is still expecting higher prices in the medium term - despite the recent rally. If that bullish skew starts to disappear in the next few days, then would consider closing the long position, but for now content to hold until closer to expiration - especially because the option position only has a relatively small amount of remaining extrinsic value (time premium).

Specifically the extrinsic value (time premium) on our long dated call option is only approximately $0.65, with the majority being intrinsic value. Extrinsic value was calculated by adding the mean bid/ask for the option price ($7.175) to the option strike ($128), then subtracting the actual GLD market price ($134.53) = approximately $0.645.

Importantly this now means that the option delta is over 90%, so the position is trading like a stock position in the underlying. Since 6 calls $128 Sept 2019 are held, that representing a 6 x 100 x option delta = 600 shares x 0.9088 position = approximately equivalent to a 545 GLD share position. That represents a notional position of approximately 545 share equivalent x $134.53 = $73,318. There are some slippage in option bid/ask spreads and the option will move as GLD moves around - but that does give a good approximation of the current position size.

Trade Update in July 2019

This is the current GLD price as of 29th July 2019, and the position has made nice progress after the trade entry on 22nd March 2019:
trading gold - Long GLD Diagonal Calendar Spread - Price chart - 20190729

The current unrealised gain loss on the Sept 2019 call position $2727, added to the $454 from May 2019 expired call, gives a total gain for the overall position of approximately $3181. This is approximately a 276% return on capital so far.

These are some possible exit strategies as the option call is getting closer to Sept 20th 2019 expiration date:

Exit long dated call at a profit - simplest technique, but does not maintain any portfolio gold exposure which will likely be a good idea in a rate lowering environment. This can be done by either just simply selling the call, or by selling dated Sept 2018 ATM calls and hoping to deliberately get called away.

Roll long dated call up and out to a higher strike - this will depend if volatility is still high (over 10%) then this would be an expensive trade. Specifically because if the long option is significantly ITM and getting closer to expiration date (Sept 2019) - it will not have a lot of time premium left in it. Rolling the call up to several months out further out will likely incur some higher than desired premium (due to the high volatility environment). However rolling out could remove all risk from the position (if done for a $1150 credit) and would maintain a multi month GLD position into 2020.

Sell long date call, and switch to using "high volatility" strategy to maintain a long gold position - e.g. bull put spread

Summary of trading gold with long term diagonal spreads

In summary on 29th July the call option position represents an equivalent $73,318 long GLD position, that was acquired with about $1150 of risk. With this strategy there was initially a 30% chance of GLD finishing in the money above $128 by expiration (based on the option delta). The probability of a touch is defined as double the initial option delta - so that also means that over the trade lifecycle there is a approximately a 60% probability of GLD touching $128. To word that in a different way it means that at some point between Mar and Sept 2019 in all likelihood there will be about a 60% possibility of taking at least some profit from the trade. Additionally because we thought GLD would go up in 2019, then we also are thinking that the stated probability was under priced. That meant that using our bullish opinion on trading gold from the macro fundamentals has given us the opportunity to put the odds on our side.

Importantly this wasn't just like a lottery ticket style infomercial that says "I make 500% a week buying options" - where the stated returns are often from buying lottery ticket way OTM options that only make that "big" money occasionally, but on average is a losing option strategy. In summary the GLD strategy had:

  • a defined theoretical probability in advance
  • limited risk/reward
  • time for the investment idea to play out

This trade shows the power of option leverage, and why it is always a good idea to structure your portfolio to respect it - even if we just happen to be on the right side of it this time. This trade is still ongoing so no decision has been made yet, however it shows how to get to good risk adjusted returns using a relatively small amount of capital.

Mexican Bearish Put Diagonal Spread

This trade idea shows how to approach trading the Mexican Market ETF (EWW) with a slightly bearish bias. If EWW maintains its position or goes down slightly over the next month, then this position is likely a winner. The strategy will only make a limited amount of money if a large sustained selloff occurs immediately. The only main directional risk to the trade is a large rally higher. This trade was IRA eligible so using multiple option legs does not generate lots of complex tax reporting, and there was no issue of paying extra capital gains if the trade is ultimately successful.

Mexican market and volatility overview

Mexico has been in the news recently due to a lot of tariff talk. This has meant that the Mexican stock market has been trending down since April 2019. EWW has had a high of $47.18 in April 2019 and a low of $41.77 in March 2019. For the majority of 2019 the ETF has been in this trading range between approximately $42 and $47. This relatively confined range and lower volatility makes it a good candidate for a diagonal spread. The trend since April 2019 has been slow ping gradually down so rather than buck the trend we can enter a slightly bearish put calendar spread to take advantage of any ongoing minor sell off.

Mexican Bearish Put Diagonal Spread- Trade Entry Chart - 20190628

The volatility chart for the last year shows a very wide range of implied volatility there was a huge spike up to approximately 43% in December 2018 when the tarriff talk was at its height. They implied volatility has moved down a lot since then six months later and by the end of June 2019 is approximately 18% which is one of the lowest readings for the year. Therefore it is a good relative volatility level to enter a put diagonal spread that will benefit if volatility increases. We can continue to express a slightly bearish opinion without over paying on trade entry for option premium.

Short EWW Bearish Put Diagonal Calendar Spread - Volatility chart - 20190628

Mexican ETF Trade Entry in June 2019

The trade entry was on 28th of June 2019 as shown in the trade below:

 
Trade Date
Category
Trans Type
Description
Symbol
Quantity
Price
Amount
28-Jun-2019
Income
Buy to Open Long Put
Put EWW 39.00  EXP 20-Sep-2019
EWW190816P42
-6.0
0.72
$434.64

28-Jun-2019
Income
Buy to Open Long Call
Call EWW 43.00  EXP 20-Sep-2019
EWW190920P43
6.0
1.52
-$914.30

TOTAL
$ 479.66

 

Summary of Mexican bearish put diagonal spread

This trade was OTM so had approximately a 40% of being ITM at expiration - it was therefore a lower probability trade. Initially selling the shorter dated put help finance the longer dated put, and reduce the overall risk in the position. The Mexican ETF EWW will hopefully drift lower over July without any major move either way.

Exiting Bitcoin Investment Trust due to Premium

This trade exit on GBTC describes how exiting Bitcoin Investment Trust due to premium was decided. The original GBTC position was purchased in March 2017. To recap the GBTC is an investment trust whose price is tied to bitcoin. The historically high premium to the actual underlying bitcoin price is the main reasoning for selling our GBTC position and replacing it with bitcoin and etheruem products that can replicate similar exposure (without that premium). This trade was IRA eligible so there was no issue of paying extra capital gains by selling after 11 months (instead of waiting for 12 months for long term capital gains to kick in).

Exiting Bitcoin Investment Trust due to Premium

The charts below compares an European based Bitcoin fund SE:BITCOIN.XBT (as a proxy for Bitcoin spot price) with GBTC. This clearly shows that throughout 2017 people have been prepared to pay a huge premium to own bitcoin in their US based brokerage account.

GBTC Feb 2018 1 year trailing premium
Bitcoin Investment Trust GBTC Trade Exit - Feb 2018 1 year trailing premium - 20180215

GBTC Feb 2018 3 month trailing premium
Bitcoin Investment Trust GBTC Trade Exit - Feb 2018 3 month trailing premium - 20180215

Combined with bullish Bitcoin 2017 price action and inflated premium, the GBTC price has moved up strongly. The above charts and Bloomberg show how the GBTC premium has moved for the last 12 months in a trading range of 50% to 120%. In only the last 3 months the GBTC premium has been as high as 120% in Dec 2017 and low as 30% in early Feb 2018. The premium trades aggressively higher on rallies and lower on sell offs. This behaviour has the effect of amplifying trading extremes, but increasingly makes it a less reliable buy and hold product.

As a recap, when the trade was entered in March 2017 GBTC premium had shrunk down to about 8% because there was the belief that a new Winklevoss Twins bitcoin ETF was about to be allowed by SEC. Once that was announcement was negative, the GBTC premium returned with a vengeance.

According to Bloomberg the average trailing 12 month GBTC premium was 53% (on 16th Feb 2017). By comparison the Bitcoin tracker fund premium was 0.08%. Additionally there is a 2.0% management fee associated with GBTC which is used to help manage the cold storage and security of the underlying bitcoin asset – so any premium paid on the actual GBTC spot price would seem to be excessive. The Bitcoin tracker fund management fee is 2.5% (higher) but since it trades at only 0.08% premium to NAV it is a relative “bargain”.

On 16th Feb 2017 GBTC had a 1 year performance return of 1,574.75% that more than double the Bitcoin tracker fund 1 year return of 774.33%. This is amazing given that the stated aim of the products is identical – the GBTC out performance results are exclusively due to premium.

For reference here are the Bitcoin and Ethereum products available that trade in Europe but can be traded in a US based brokerage account. These products do not have a huge premium to spot bitcoin and are IRA eligible. Bizarrely the swedish Krona product has the higher volume, over the Euro based product. All of these fund products introduce some currency risk exposure, but that is likely less to be way less variable than the GBTC premium risk.

CoinCurrencyInfo
Bitcoin Swedish KronaCOINXBT:SS
Bitcoin EuroCOINXBE:SS
Ethereum Swedish KronaCOINXBE:SS
EthereumEuroCOINETHE:SS

A Good Trade but Poorly Traded

This GBTC trade was ultimately a great investment, but one that was traded frustratingly poorly.

A small tranche was sold in May 2017 to cover the risk on the original position and the rest was left to run as “house money”. Clearly with hindsight that was the “wrong” thing to do, but is it good risk management on a very volatile product – and allows staying in the trade for a much longer amount of time. This risk management part was not poor trading, but the management of the resulting price action in 2017 can be improved – as discussed below.

The final run up into Dec 2017 was not well traded, and therefore missed the significant peak at $39, and survived the drop to $10 in Feb 2017, so decided to exit with some value still intact at $18. This is a very hard trade to take psychologically because of the anchoring to the high point at $39. However the 1300% returns in less than a year is still amazing, yet disappointing from a trading perspective. The split adjusted entry point was $1.44 so clearly this was all “house money” but some exit trading at higher prices should have been achieved into the Dec 2017 peak. This is not purely hindsight – it was clear the short term nature of the blow off top, even during Dec 2017. This does not mean the end of the bitcoin “bubble” – just a medium term trading top that should have been taken advantage of.

Bitcoin Investment Trust premium – Trade Exit

GBTC premium expands on rallies (up to 120% in Dec 2017) and contracts on huge sell offs (down to 30% in early Feb 2017). On trade exit at about $18 that is approximately an average 80% premium, which is somewhere in the middle of the range extremes for the last year. On trade exit with bitcoin at approximately $10k, the book value (or NAV) of GBTC was about $10, therefore there is approximately $8 of premium to nav (or about 80%). Therefore about 1800 shares of GBTC buys approximately one bitcoin, but the book value is about 1000 shares. Clearly there is a convenience premium, but 80% over book value is very high. That does not mean GBTC price cannot rise further, or the premium increase more in 2018. However if the premium ever shrinks to say 30% then it is quite possible to lose money in GBTC even if the bitcoin price goes up. When you buy GBTC at $18 about 45% of your purchase is premium (or “fluff”) over the price of the underlying bitcoin. That is a very hefty premium to spot.

Trade Entry was at GBTC split adjusted $1.44 (actual pre split price at that time was $131) in March 2017 when bitcoin was approximately $1250. Trade exit was $17.96 when bitcoin was about $10025 in Feb 2018.

Trade Replacement

The GBTC investment can be replicated without premium using the Bitcoin tracker funds. Since 1000 shares of GBTC represents approximately 1 Bitcoin, these trading approaches could be taken:

1. Sell 1000 shares of GBTC ($18,000 USD) and purchase $10k Bitcoin tracker fund – this maintains exactly 1 Bitcoin exposure. The remaining $8000 premium can be maintained as cash for future purchases if there is a pull back or for other investments. This maintains bitcoin only exposure.

2. Sell 1000 GBTC then purchase $10k Bitcoin tracker fund and $8k Etheruem tracker fund. This gives exactly 1 Bitcoin exposure but allows using the GBTC premium to buy a new Etheruem position. This has created a slightly more diversified crypto portfolio – but still fully invested in crypto, with no cash on hand.

3. Sell 1000 GBTC then purchase $6k Bitcoin tracker, $6 Etheruem, and keep $6k cash. This gives a less aggressive portfolio because it keeps some cash on hand in case of a pull back.

4. Sell GBTC and maintain cash to wait for a big pullback to invest. If you are a believer in the long term crypto currency bull, this is arguably the biggest opportunity risk – crypto prices are hard to predict and can be notoriously bubbly – so it having exited once at lower prices it is hard to reestablish at significantly higher prices.

These reallocation strategies are all tax optimal in an IRA.

Summary

There is a significant chance that if there is a bullish BTC price march in 2018 towards $20k again then GBTC will do very well. Indeed one day later BTC is already trading 10% higher at $11,000 (so clearly this is proving a badly timed exit). However there need to be discipline to recognize when that the GBTC trade now has premium risk outside of just Bitcoin spot price risk. That risk can be resolved by selling GBTC and buying bitcoin tracker funds.

This is not necessarily a price extreme for bitcoin, but a potentially a premium extreme in GBTC. Still bullish on bitcoin and crypto assets for the next few years, however GBTC may not prove to be a good long term buy and hold product (due to the premium).

In summary this is not purely a bitcoin play, but has become a play on the premium investors are prepared to assign for the convenience of exchange traded bitcoin product. Importantly selling GBTC is a not a bearish call on bitcoin or crypto in general, just trying to avoid being the last one out when playing musical chairs with the premium trade.