Today's trade is something I don't do much of: a pairs trade, but with an options twist.
A typical pairs trade goes like this: You find two stocks that typically trade together, but for some reason, they've diverged. So, you buy the underperforming stock and short-sell an equal dollar amount of the outperforming stock. This is typically a market-neutral trade where you're betting the values of the two stocks will eventually resume their normal parity, resulting in a net profit from the two trades.
We have a situation developing right now that screams pairs trade to me, but I'm going to do it with options.
Notice the divergence in Gold $GLD and Silver $SLV of late?
These two metals tend to be highly correlated.
Is Gold overbought? Is Silver going to play catch-up? I'm willing to bet one or both is true, and today's trade is an attempt to profit from this relationship returning to its historical norm.
Here's the Play:
I'm putting on two trades. You can think of each as two separate trades if you like. I think each stands on its own. But for me, it's a pairs trade, and I'll be entering and exiting each together.
I like buying a $GLD 310/290 Oct Bear Put Spread for approximately $13.00 net debit. The spread wins if $GLD is below 297 on expiration day. The max risk is the debit I pay today. The most I can win is $7.00 (the difference between the strikes minus the premium I pay today).
Additionally, I like buying $SLV Oct 31 Calls for approximately $2.25 per contract. I will size this SLV position FIVE-TIMES the size of my GLD position to keep the dollars at risk approximately the same in each underlying.
I'm doing the spread in $GLD because the implied volatility in those options is currently high, so a spread increases our odds of success. Plus, I'm not bearish gold. I'm buying the simple long calls in $SLV because the premiums are cheap, and I think it's a higher likelihood that $SLV catches up versus $GLD catching down.
My risks are defined. It's highly unlikely I would lose on both sides of this trade. If one loses, it's likely the other wins. So, no stops for this trade. I'll check in on it from time to time to determine when to take my profits.
If you have any questions about this trade, please send them here. As always, stay updated on the latest in the ASO chat room.
If you missed my most recent ASO video Jam Session, you can catch a replay on Stock Market TV.
