If you have been in this business for any length of time then chances are you have accumulated something of a “toolbox” of trading methods. Some tools you use actively to trigger actual buy and sell decisions, others you “keep an eye on” in order to help filter the good signals from the bad. And of course, if you’ve been around long enough and you’ve developed enough different methods, every once in awhile you get enough conflicting signals so as to generate “analysis paralysis” and find yourself unable to pull the trigger one way or the other (“Hi, my name is Jay”).
But every once in awhile the “stars align”, “all the pieces fall into place”, “everything comes together” and [your favorite cliché here]. And often, such a configuration can lead to some of your best opportunities, and as a result there can be a temptation to “put the pedal to the metal”, to “raise the ante”, to “use more leverage” and [your other favorite cliché here].
And there lies the danger.
It makes perfect sense to trade more aggressively when you perceive that all the key components of a good trade are falling into place. Within reason. Which leads us to:
Jay’s Trading Maxim #44: At no time are money management and risk management more imperative than when everything looks like it’s all about to come up roses. Or to put it more succinctly, you are at your greatest risk when your defenses are down.
The Setup in Gold Stocks
There are three parts to the setup:
#1. A Bearish Seasonal Period
Last week in http://www.optionetics.com/market/articles/2012/09/27/kaeppels-corner-picks-to-click-in-the-month-of-october I mentioned that gold stocks have demonstrated a historical tendency to perform quite poorly from the end of September through the 19th trading day of October. As evidence I include once again the chart displayed in Figure 1 that shows the historical performance of gold stocks (using Fidelity Select Gold – ticker – FSAGX – as a proxy for gold stocks) between the end of October and October trading day #19 from 1989 to the present.
Figure 1 – Decline of $1,000 invested in FSAGX from end of September through October Trading Day #19 (since 1988)
#2. A Loss of Momentum
On September 5thh http://www.optionetics.com/market/articles/2012/09/05/kaeppels-corner-taking-what-the-market-gives-back I wrote about a bearish setup that often highlights securities that seem to be performing alright but which are losing momentum “under the surface.” The three parts to this setup that I mentioned in that article are:
-The MACD indicator (using 18/37/9 as defaults) is bearish
-The 28-day Rate-of-Change indicator is bearish
-3-day RSI rises above 70 for at least one day, and then ticks lower.
At the moment, MACD and ROC are both bearish. The 3-day RSI did not hit 70, however I also monitor readings above 64 (instead of 70) as a potential signal if other factors are also in line.
Figure 2 – GDX price action looks good, but stock potentially losing momentum “under the surface”
#3. The Elliott Wave
The Elliott Wave count generated by HUBB ProfitSource technically is bullish at the moment. However, as you can see in Figure 3, it is suggesting the possibility of a pullback to the 47.20-49.10 range between Waves 3 and 4 during the month of October.
Figure 3 – Elliott Wave count suggests a possible pullback during October
So one could argue that a fair amount of evidence is mounting on the bearish side for gold stocks. So does this guarantee that gold stocks are about to tank? Hardly. Still, this does offer a potential opportunity to use options to enter into a limited risk position that could profit handsomely if by chance gold stocks do fall apart. For illustrative purposes, let’s consider one possibility.
A Bearish Play on GDX
I am well aware that options offer the potential to create a lot of “creative” positions. But when you absolutely, positively want to play an outright bullish or bearish idea, sometimes it is tough to beat just buying a call or put option. Me personally, when it comes to straight up call or put buying I like an option with a lot of “Gamma” (As succinctly as possible, "Gamma" represents the amount that an option’s “Delta” will change given a $1 move by the stock. “Delta” represents the expected change in the price of an option given a $1 move by the stock. So high Gamma means that if the price of the stock moves as expected, you have the chance to gain a lot of ground quickly on a percentage basis).
Ticker GDX is an exchange-traded fund that tracks a gold stock index. So let's look at a position using a GDX put option with "high Gamma".
Figures 4 and 5 display a position that involves buying one November GDX 54 put option for $2.55 (or $255)
Figure 4 – November GDX 54 put
Figure 5 – Risk curves for November GDX 54 put
As you can see, if GDX does in fact fall into the 47.20-49.10 range by the end of October this position would generate a profit of between $240 and $420 on an investment of $255.
This seems like a good time to reiterate the key point of this article, I.e., that there is no guarantee that gold stocks will decline anytime soon so we are using a put option position with limited dollar risk to play the short side, rather than one of several other alternatives including:
-Selling short gold futures (which is technically quite a different thing than trading gold stocks).
-Selling short shares of GDX (which requires maintenance margin and which theoretically involves unlimited risk if a person is crazy enough not to enter a stop-loss order).
-Buying the ETF ticker DUST, which is a triple-leveraged inverse gold stock ETF (and which is one of the most volatile securities known to man),
Position Sizing and Risk Management
A trader with a $25,000 account who is willing to commit up to 5% of his capital to one position, or $1,250 ($25,000 x .05), could buy up to 5 contracts of the Nov GDX 54 put option. Ideally one would then hold the position through 10/25/12 (i.e., October Trading Day #19) and collect the profit.
On the other hand - if you look at the green risk curve line in Figure 5 - you will note that even if gold stocks do rally instead, this option will not lose all of its value by late October as there will still be 3+ weeks left until November option expiration, so the option will retain some time premium. To put it another way, as long as you exit the position by October 25th, the GDX 54 put option will retain some value, thus you will not experience something less than the maximum loss of $255 per contract (which granted, doesn't sound all that comforting but which nevertheless, is a good thing).
Summary
Investing and trading is a game of odds. The keys to success then are to:
a) Put the odds as much in your favor as possible
b) Maximize your profitability when things work out in your favor
c) Minimize your risk when things go the wrong way (which they inevitably will from time to time)
As we’ve seen, one could make the argument that the odds are favoring a decline in gold stocks in the weeks ahead. Likewise, while there are many other possible ways to play, the position I highlighted stands to profit handsomely if gold stocks decline and the dollar risk is limited to $255 per contract if god stocks rally instead.
On your marks, get set……….
Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
