When last we spoke about the topic of gold stocks, I wrote about, a) the tendency for gold stocks to advance during early May (http://www.optionetics.com/marketdata/article.aspx?action=detail&aid=24347, and, b) how utterly and completely that idea failed this time around (http://www.optionetics.com/market/articles/2012/05/09/kaeppels-corner-what-to-do-when-you-look-like-a-fool).  So thanks for bringing it up again.  But there are a number of key lessons to be gleaned.

Lesson #1 involves invoking once again:

Jay’s Trading Maxim #5: The markets don’t always do what you want them to do.

And then some, in this case.  Between May trading day #1 and May trading day #15 – which was supposed to be a bullish period - ticker GDX, an exchange-traded fund that tracks gold stocks, lost –7.4%.  Ouch.  This leads us directly to:

Jay’s Trading Maxim #27: How right or wrong you are on a given idea matters not a wit.  The only thing that really matters is how much money you actually make or lose in the process.

To wit, while the timing clearly could hardly have been worse, the position I discussed in the 5/1/12 article involved buying two GDX June 47 calls for a total cost and dollar risk of $356.  As I write, this position has lost $282.  Now I can’t speak for anyone else, but I can personally withstand a lot of looking stupid if the resultant actual loss of capital is just $282.

Bottom line, so far I’ve weathered the storm relatively unscathed.

So Here We Go Again

In the 4/18/12 article I wrote about three time periods:

April21 – this refers to the performance of FSAGX during the last 21 trading days leading up to the last trading day of April.

MayTD2-15 – this refers to the performance of FSAGX between the close of May trading day number one (5/1/12) and May trading day #15 (5/21/12). 

MayTD15-JunTD9 - this refers to the performance of FSAGX between the close of May trading day number one (5/21/12) and May trading day #15 (6/13/12). 

The relevant figure here is this:

Since 1989, if April21 AND MayTD2-15 are BOTH DOWN (check):

-May TDM 15 through June TDM time period has been up 9 times and down only 3 times.

In other words, if gold stocks show a loss during both the April21 and MayTD-15 time periods, then the MayTD15-JunTD9 period has showed a gain 9 out of 12 times.  Thus, the implication now is bullish and based on this we should be once again looking to play the bullish side of gold stocks (gulp!).  As a result, I suggest exiting the June 47 GDX calls and entering a new position, which I will discuss in a moment. 

Getting Your Head Unscrewed, er, Screwed on Right

So will this new position be my “redemption?”  Will gold stock prices soar over the next several weeks, leading to a gain which wipes out the previous loss and generates a net profit?  Will I look like the self assured speculator who sticks to his guns and wins in the end?  Or will I look even dumber in a couple of weeks. 

In all candor, the answer is “who cares?”  I base this blasé attitude on:

Jay’s Trading Maxim #77: To invest your money in a good idea is wise.  To invest your ego in any position, not so much.

Finding a Position

So here goes.  It’s decision time.  The question at hand is what position to put on now in hopes of making money if gold stocks really do – no seriously, I really mean it this time – rally between now and 6/13.  As always – especially for those who use options - there are choices.  In fact, in an ironic twist of fate this leads directly to:

Jay’s Trading Maxim #115: The greatest thing about trading options (there are so many possibilities) is also – ironically – the very worst thing about trading options (there are so many possibilities).

In this case, because we are looking (hoping?) for a short-term advance in gold stock prices I am going to look at the June options.  There is risk involved here because our target exit date is 6/13 and June options expire just two days later on 6/15.  This means that because of time decay, any time premium that we pay to buy a June option will be just about gone by the time the thirteenth rolls around. 

The bottom line here is that if one buys June call options now with the idea of selling on 6/13, the risk of a complete loss of investment is very real.

Possibility #1 – The Stock Replacement Approach

With this approach we will try to minimize the negative effect of time decay by buying an in-the-money option that is comprised mostly of intrinsic value.  For this we will look at buying two GDX June 40 calls at $3.75.  As of 5/21/12, GDX was trading at 43.01.  So if we add the strike price of the option (40) to the cost of the option (3.75) we get a breakeven price of 43.75.  So GDX must rise to at least that price in order for this position to make money.  Above that price the option will move point for point with the price of GDX itself.

Figure 1 – GDX June 40 Calls

Figure 2 – GDX June 40 Calls

Possibility #2 – A More Aggressive Play

A more aggressive play with about the same dollar risk would be to buy two of the at-the-money June 43 calls.  As of the close on 5/21 this option was trading at 1.73.  So the breakeven price on this position is 44.73 (43 strike price plus 1.73 option price).  To put it another way, if GDX does anything besides rally 4% (i.e., from 43.01 to above 44.73) in the next 16 trading days, this position loses money. 

Figure 3 – GDX June 43 calls

Figure 4 – GDX June 43 calls

So with Possibility #1 and #2 the key thing to remember is that if gold stocks do anything but rise immediately - and fairly sharply - in the weeks ahead, these postiions will likely lose money.  If you are uneasy about this, then see Possibility #3.

Possibility #3 – The "Alternatives"

As I alluded to with Trading Maxim #115, there are many other possibilities.  There is any number of spreads that might be used and one could certainly consider using longer term options to minimize the potential perils of time decay.  The tradeoff here is that longer-term options will have less upside potential (as well as less likelihood of sustaining a complete loss by 6/13).  And there is nothing wrong with exploring such possibilities on your own.  However, I am viewing this as strictly an aggressive timing play on an advance in gold stocks in the next several weeks (hmmm, feels like déjà vu all over again).  So for this one I am relying heavily upon:

Jay’s Trading Maxim #212a: If you’ve made the decision to “go for the gusto”, then for crying out loud man, just go for the gusto.  

and the all important addendum...

Jay’s Trading Maxim #213b: "Gusto" ain't always all it's cracked up to be, so if you’ve made the decision to “go for the gusto”, remember not to lose your shirt in the process.

Both Possibility #1 and Possibility #2 qualify and "very aggressive" plays.

Summary

So here I stand again, writing an article proposing a bullish position in gold stocks.  Given all that has transpired up until now, it's hard to be  optimistic.   

Of course, contrarian thinking being what it is - maybe that’s a good thing....

Jay Kaeppel

Staff Writer and Trading Strategist

Optionetics.com ~ Your Options Education Site

NOTES:

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