Please be sure to read Words to Trade By
There is something about gold mining stocks that causes some traders to act somewhat irrationally at times (“Hi, my name is Jay”). Maybe it’s the volatility and their ability to move sharply higher (and alas, much lower) quickly and the adrenaline rush that that can cause. Maybe it’s just the overall “mystique” about gold. Whatever.
The bottom line is that gold stocks can cause a person who is typically very disciplined trend followers into raving “I think I can pick the bottom” maniacs (repeating now, “Hi, my name is Jay”). Now most traders have been told time and again that trying to “pick a bottom” in a down trending security is a fool’s errand. And the truth is that there is a lot of, well, truth to that notion. But there are “ways to do things”.
The Current Situation in Gold Stocks
In Figure 1 you can see the monthly action in ticker GDX (an ETF that tracks a portfolio of gold mining stocks).
Figure 1 – Monthly ticker GDX (Courtesy: AIQ TradingExpert)
Two things to note in Figure 1:
1) Price is quite close to a multi-year low
2) It wouldn’t take much of an advance to break above a multi-year downtrend
Hence the “critical juncture” reference in the title.
In Figure 2 we see a daily chart for GDX.
Figure 2 – Daily ticker GDX with RSIEverything (Courtesy: AIQ TradingExpert)
As you can see in Figure 2, GDX appears to be “coiling” within a triangle pattern, an action that get’s traders very excited about what might happen next (again, “Hi, my name is………..oh, never mind). Also, while the overall trend is inarguably “down”, recent oversold reading in my RSIEverything indicator have been followed by “bounces” in the price of GDX. Both of these factors point to the potential for a move higher.
So one of three things will happen:
1) Price will break out to the upside
2) Price will continue to consolidate and move sideways
3) Price will break down to a new multi-year low.
So what is a trader who “wants to believe” (that gold stocks will rally) to do?
Using Options to Trade Gold Stocks
While picking a bottom as a regular diet is not a good idea, via the use of options a trader can “take a shot” without betting the ranch. So based on the three possibilities listed above, I want to look for a trade that:
1) Will make a high rate of return if gold stocks move higher
2) Will not “waste away” if price moves sideways for a while
3) Won’t lose a ton of money if price falls apart
Before selecting an option trade let’s consider the current level of implied volatility in GDX options. This is important because the level of implied volatility tells us whether the amount of time premium built into the price of GDX options is “high”, “low” or somewhere in between.
Figure 3 is a screen shot from the software that I use for my options analysis (ironically titled www.OptionsAnalysis.com) displays the price chart for GDX for roughly the last four years along with the implied volatility for 90 day options on GDX.
Figure 3 – GDX with 90-day implied option volatility (Courtesy: www.OptionsAnalysis.com)
As you can see at the moment we are currently smack dab “somewhere in between” high and low. This tells us that there is no significant advantage to “buying premium” (which is favored when implied volatility and time premium is low) or “selling premium” (which is favored when implied volatility and time premium is high).
So under these circumstances I want to look for a trade that:
1) Has more upside potential then downside risk
2) Involves buying premium, but;
3) May also involve selling premium in order to offset some of the cost of the options purchased.
4) Leaves a lot of time before I have to worry about time decay adversely affecting the position (since two of the three potential scenarios I listed earlier involve something other than “gold stocks going up”).
A Bull Call Spread
In this example, I am going to highlight one possibility which involves a “Bull Call Spread” using January 2016 call options. The particulars are highlighted in Figures 4 and 5.
Figure 4 – GDX Jan16 Bull Call Spread (Courtesy: www.OptionsAnalysis.com)
Figure 5 – Risk Curves for GDX Jan16 Bull Call Spread (Courtesy: www.OptionsAnalysis.com)
At the time I looked at this trade it could be bought for $130 for a 1-lot. So if GDX falls apart the worst thing that can happen is that the trade loses $130 per 1-lot. This trade has 177 days until expiration so whether GDX rallies now or rallies later is not really of critical importance. However, please note that once the trade moves into profitable territory, time decay actually helps the profitability of this trade due to the fact that the option sold will lose time premium at a faster rate than the option purchased.
If GDX reaches:
1) Its recent high of $23.22 this trade will show a profit of between $80 and $180 (depending on how long it takes to reach that price).
2) Its July 2014 high of $27.78 this trade will show a profit of between $200 and $370 (depending on how long it takes to reach that price).
3) Its August 2013 high of $31.35 this trade will show a profit of between $270 and $370 (depending on how long it takes to reach that price).
Summary
As always the trade I have highlighted is not a “recommendation”, only an example of one way to use options to take advantage of a particular outlook (OK, more like a “Hope” in this case) without risking large amounts of trading capital. It also highlights several factors that traders should consider before entering into an option trade (i.e., what are the likely scenarios and how will this position be affected in each case) and the importance of considering implied volatility when electing an option trading strategy.
Jay Kaeppel
