Is this going to be another big run up in the price of Gold? I don’t know that for certain, but I do know that if I use options to trade my bullish outlook then I can limit my maximum risk to a given amount whilst still taking advantage of any sizeable increase in the price of Gold.
The Gold futures market is capable of large price movements over night and shares in Australian gold companies can gap substantially when our market opens.
Due to the way that options work, any adverse moves generally result in much lower losses with options than you would normally have if you were holding the shares.
I will be using options on Lihir Gold (LGL) to trade the gold price. As you can see from the ProfitSource weekly chart shown in Chart 1, where I have used the chart overlay function over the last 12 months to show that LGL has tracked the price of gold when compared to the GLD, the Exchange Traded Fund for gold on the US market.
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Based on what I see in this comparison, if Gold rises to around US$900 an ounce, then LGL should go to around $3.25 a share.
In this instance, to minimize my risk I’m going to trade well out of the money (OTM) options. I will buy the January 09 Call options at the strike price of $3.00. These are currently trading at around 10 cents each, or $100 per contract. If I am correct about gold and LGL, then these options could easily double in value before they expire, giving me a 100% return on my investment.
Now, if I compare that to buying 1000 shares of LGL, at a cost of $2200, I could potentially, although not likely, lose the entire $2200 if LGL went to zero.
The plan for this trade is quite simple. I’m prepared to risk $500 on the trade so I will only purchase 5 contracts for a total outlay of $500 as I am not setting a stop loss. I could purchase 10 contracts and place a 50% stop loss based on the value of the options and theoretically still only be risking $500. However, given the way that Gold gaps in price I may find myself stopped out of the trade prematurely as I was on my STO oil trade recently.
The trade is, buy to open, 5 of the January 09, $3.00 Call contracts at 10 cents ($100 per contract). Shown in Chart 2 is an OptionGear risk graph of the trade.
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As I said, there is no stop loss on this trade because I am only taking half the normal position size. I will only set a time stop and that will be the 15/01/2009, one week before the options expire.
The profit stop is when I can sell the options for a minimum of 20 cents each ($200 a contract). I can actually place that as a good till cancelled order with the broker as soon as I buy the options.
This is a basic trading plan. I could place a trailing stop on my profits, or I could look for a larger return in the first place. However, before you open any trade you must have a plan and this is the one I will be using.
Remember, you always have options