A lot of people seem to think that speculation is anywhere from “foolish” to downright “evil”. I disagree. I believe that “risking a couple of bucks” in hopes of making “a whole lot more” makes a lot of sense. I especially like to emphasize the “risking a couple of buck’s part”. Once Old School, always Old School I guess.
A “speculative” position in my dictionary is one that stands a chance of going against me at any moment. In other words, if I enter a speculative position I must stand ready to exit immediately if my exit criteria is hit – even if that occurs on Day 1 (I have experienced this and can verify that it is not fun).
The key is to limit how much you risk. One great way to do this is to use options. Let’s consider an example.
(See also The Value of the ‘Perspective’ Indicator)
The U.S. Dollar
The U.S. dollar enjoyed a strong advance from mid-2014 into March of 2015. Since that time it has moved sideways to lower and is now close to a critical support level. Figure 1 displays a bar chart for ticker UUP – an ETF that tracks the U.S. dollar. The critical support level is $24.19 a share, which I have labeled as the “line in the sand”. I refer to it this way for two simple reasons:
*As long as price holds above this line there is the potential for higher prices
*If price drops below this level then all bets are off.
Figure 1 – Ticker UUP (Courtesy ProfitSource by HUBB)
Speculating with Call Options
The truth is that I have no idea whether or not this line will hold – not for a day, a week, a month or more. But I do know that by buying a call option on UUP it is possible to obtain a profit-to-risk potential of at least 2-to-1. Figures 2 and 3 show the particulars of buying the June 24 strike price call option.Figure 2 – UUP June 24 call (Courtesy www.OptionsAnalysis.com)Figure 3 – UUP June 24 call option risk curves (Courtesy www.OptionsAnalysis.com)
As you can see in Figure 3:
If price falls below $24.19 the loss will be somewhere between -$18 and -$35 per option contract depending on how soon the breakdown occurs.
If price reaches the first profit target of roughly $25.25 (which represents a 1-standard deviation move in price) the profit would be roughly +$75 per option contract.
If price reaches the second price target of $25.57 (which represents the recent high made on 3/2) the profit would be roughly +$110 per option contract.
Is it a good idea to risk money on a bullish position in the U.S. dollar right this very minute? I am not saying that it is or isn’t. The point of this article is simply to point out the potential to turn a speculative situation into one with:
*A profit-to-risk potential of at least 2-to-1
*A clearly defined exit point
Hey maybe this Old School stuff isn’t so crazy after all….