Gold has certainly had another nice little run up over the last few weeks and maybe we have to ask ourselves, did we miss an opportunity to profit from this? As it turns out we probably did, but we can still use a strategy that could capture either a further run up or a sudden drop in the price.
This strategy is called a Straddle, and it involves buying both a Call and a Put at the same time. It is used when you expect a share price to move, but you are not sure in which direction it will go.
Looking at the Elliott Wave Pattern on a daily ProfitSource chart, we see that Lihir Gold (LGL) is in a classic Wave 4 Up, with a price projection of about $3.50 in the short term. The Oscillator is also nicely formed, showing a pullback from the Wave 3 high with a gentle slope back up again. Notice though, that the strength of the Oscillator is now far less than the peak of the Wave 3, even though the share price is higher. This indicates that the run may be coming to an end. See chart 1.
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The mechanics of this trade are quite simple - we want to give ourselves a little bit of time to be right, but on the other hand we don’t want to spend too much. So we will be using March 09 options and the order that we give to the broker would be for a spread and it would look like this:
Buy to open 1, March 09 $3.25 Call option, while at the same time Buy to open 1, March 09 $3.25 Put option, for debit of 60 cents or $600 per contract (60cents x 1000 shares per contract)
This means that both options would be bought at the same time for a limit price of 60 cents. It doesn’t matter what the individual options cost.
With this type of trade we are not particularly concerned which way the share price moves, but it will have to move at least 30 cents in either direction over the next 4 weeks for us to make a profit. See Chart 2 showing OptionGear Risk graph of the trade.
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As you can see from the risk graph, the share price doesn’t have to move 60 cents in one direction to start making a profit on this strategy. It just has to move in the short term. Other factors such as an increase in the Implied Volatility of the options could also increase the profit.
The plan for this trade is fairly straight forward.
The time stop is 30 days to expiration, that is, sell the options on the 26th February, regardless of the share price. As we can see from the risk graph, the green line represents this time frame and shows that the risk on the trade at that point is about $100.
The profit stop is 20%, that is, sell the spread for 75 cents. In fact, we can place that order as soon as we are filled on the trade and then just wait. Normally though we would watch the trade for about a week before we placed the sell order, just in case there was a sudden, large move.
The reason that we place the sell order early is that it’s quite easy to miss our profit target if the Volatility of the options or the actual share price spikes up and down intra day and you are not sitting in front of the computer.
Remember, you always have options,