During Tuesday’s YouTube Halftime Report, the topic of bull call spreads on GLD came up. Coach Mark built a LEAPS spread with a very attractive risk-reward. The low cost was quite surprising, but we didn’t have much time to explore the dynamics of why. So that’s what we’re doing today.

The Setup

The gold ETF, GLD, made its way into our weekend Options Report due to its clean breakout pattern. For two months, the yellow metal has been playing ping-pong with $157 and $165. The stalemate was finally broken, and bulls declared the victor with Monday’s breakout.

In an ideal world, GLD would immediately take flight, spurred by fresh buyers responding to the resistance breach. But if you look at gold’s history, its performance post-breakouts is spotty. Sometimes it runs, but other times the ascent is a slow grind requiring patience before payment.

So far, the current episode is following the latter template.

The Spread

Some think that long calls are the go-to stock substitute. This is true if you’re using deep-in-the-money calls. But if you’re using calls with a strike near the current stock price (aka close-to-the-money), then they actually aren’t a very good proxy for stock. There’s too much time and volatility risk. A better choice, in that case, is the bull call spread.

Because you’re both buying and selling options, the time and vol risk is mitigated while the delta remains. The basic structure consists of buying a lower strike call while selling a higher strike call against it.

In the case of GLD, we were looking at buying the $165 strike and selling the $185 strike. How far away you go on the higher strike depends on how bullish you are and what the time frame is. I wouldn’t use $185 if I were trading one-month options because there’s little chance GLD will actually get there. But, if I were using six-month or one-year options, then it’s doable.

The month chosen comes down to preference. In our case, we were looking at a long-term bullish trade, so we used January 2021 options. In doing so, it made the use of the $185 far OTM strike feasible.

The Jan $165/$185 call spread trades for $5.85, and thus carries $585 of risk, but a whopping $1,415 of reward. That translates into a potential return on investment of 242%. For buying a slightly ITM call and selling a not that far OTM call (the delta of $185 strike is 30), the cost seems cheaper than it usually would be. For example, I built a similarly structure bull call using January options on AAPL, and the ROI was only 166%, not 242%. So what is it about GLD that makes the bull call so sexy? What are the dynamics that are driving this?

The Tale of Upside Skew

After a bit of sleuthing, I discovered two characteristics of GLD options that are behind the asymmetric payout of bull call spreads.

First, the lower implied volatility levels.

Second, the upside call skew.

A Killer Combo for Call Spreads

GLD options trade with lower absolute implied volatility due to the steadier, slower-moving nature of the asset. Picture stocks as people moving through a pool of water, and gold as humans moving through a pool of molasses. The implied volatility for GLD options is 20%. By comparison, S&P 500 options have an implied volatility that is more than 50% higher at 33%.

As a result, calls trade cheaper on GLD.

In isolation, this fact would suggest that long calls in GLD are the way to go, but it was a call spread that was so darn attractive. The reason has to do with skew.

Typically, call options get cheaper in implied volatility terms as we move further OTM. In other words, upside calls trade with lower IV than ATM calls. The reason is simple. IV is driven by demand. If the IV of one strike is lower than another, it’s because the demand is lower. Or, you could say the supply is higher. OTM calls generally trade cheaper on stocks because of the popularity of covered calls. Another reason is that stocks don’t usually crash up; they crash down. So the fear is to the downside.

Gold is a different animal.

Its OTM options trade with higher IV than ATM options. Upside calls trade rich in GLD. They are in greater demand, primarily because the fear with gold is to the upside. While people panic out of stocks, they panic into gold.

As a result, OTM calls for GLD trade rich. For stocks, it’s the OTM puts that are juiced.

The January $165/$185 bull call spread in GLD consists of buying a lower IV option (20.97%) while selling a higher IV option (23.26%). The skew is what is causing the sexy ROI. As long as this phenomenon exists, and I think it will always be here with GLD, bull call spreads will be an attractive play.

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