Instead of going short TLT, an investor could purchase put options on TLT at the expectation of a rate increase. A hypothetical comparison of expiry profit and loss of shorting TLT versus purchasing an at-the-money put option on TLT is shown in Figure 8. In this example, TLT is trading at $124 when both positions are initiated. The put option is struck at $124 for an upfront cost of $3.00. At expiry, both positions pay off if TLT declines below $124, with the put option position making $3 less (the upfront premium). If TLT finishes higher than $124, the short position is subject to uncapped losses. However, the put option’s losses are capped to the upfront premium paid. The capped loss in the put option position is attractive if an investor mistimed the Treasury rate increase.
Example 2: A Put Spread Hedge On GLD To Reduce Risk In Being Long Gold
With the increased demand for exposure to gold in the last few years, GLD has been a widely traded ETF, and its options are some of the most liquid among ETF options (the most liquid of all commodities and also higher than some of the largest equity ETF options). Perceived as a “real” asset, investors look to hold gold in times of widespread macroeconomic uncertainty.
An outright position in GLD is subject to the volatility in gold prices. However, the risk to a long position in GLD can be reduced by overlaying a put spread on top of a GLD position. A put spread purchases a near-the-money put and sells a farther-out-of-the-money put with the same maturity. The cost of the near-the-money put is partially offset by selling the farther out-of-the-money put. The near-the-money put provides full downside protection in the underlying. Often though, complete downside protection is too costly, and it is beneficial to sell a farther-out-of-the-money put that caps downside protection, but also decreases premium paid.
The profit and loss at expiry of a hypothetical put spread on GLD is shown in Figure 9. In the example, GLD is at $150 at trade initiation, and the put spread strikes are $146 for the long put and $139 for the short put. The total cost of the put spread in this example is $1.00. We assume this put spread is overlaid on a long GLD position. The put spread will protect holders of GLD from any losses between $146 and $139, while still participating in GLD upside (less the upfront amount paid for the put spread).