This Gold Trade Could Deliver 133% Returns in 12.5 Months

Gold had its first negative year in more than a decade as the bullish bias all but disappeared among investors. It has now experienced a 35%-plus drop from a record high above $1,900 an ounce in 2011.

The June lows were tested in the past few weeks, but a bullish divergence (new lows in price without new highs in volatility) suggests the type of technical bottom that often puts in a long-term price base.

SPDR Gold Shares (NYSE: GLD) is off 29% year to date, while the Market Vectors Gold Miners ETF (NYSE: GDX) has been hit even harder with a 55% decline. Therefore, miners offer greater reward to risk if and when gold stabilizes and recovers.

GDX is trading near its decade-plus lows around $16, which were made in 2008. A rally to the top of the nine-month trading channel at $30 is my initial target.

The $30 target is about 45% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could see a 133% return on a move to that level.

[ad#Google Adsense 336×280-IA]One major advantage of using a long call option rather than buying a stock outright is putting up much less capital to control 100 shares — that’s the power of leverage.

But with all of the potential strike and expiration combinations, choosing an option can be a daunting task.

You want to buy a high-probability option that has enough time to be right, so there are two rules traders should follow:

Rule One: Choose a call option with a delta of 70 or above.

An option’s strike price is the level at which the options buyer has the right to purchase the underlying stock or ETF without any obligation to do so.

(In reality, you rarely convert the option into shares, but rather simply sell back the option you bought to exit the trade for a gain or loss.)

It is important to buy options that pay off from a modest price move in the underlying stock or ETF rather than those that only make money on the infrequent price explosion. In-the-money options are more expensive, but they’re worth it, as your chances of success are mathematically superior to buying cheap, out-of-the-money options that rarely pay off.

The options Greek delta approximates the odds that an option will be in the money at expiration. It is a measurement of how well an option follows the movement in the underlying security. You can find an option’s delta using an options calculator, such as the one offered by the CBOE.

With GDX trading near $20.64 at the time of this writing, an in-the-money $16 strike call option currently has about $4.64 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option currently has a delta of about 81.

Rule Two: Buy more time until expiration than you may need — at least three to six months — for the trade to develop.

Time is an investor’s greatest asset when you have completely limited the exposure risks. Traders often do not buy enough time for the trade to achieve profitable results. Nothing is more frustrating than being right about a move only after the option has expired.

With these rules in mind, I would recommend the GDX Jan 2015 16 Calls at $6 or less.

A close below $16 in GDX on a weekly basis or the loss of half of the option’s premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $600 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2015 options give the bull trend over a year to develop.

This trade breaks even at $22 ($16 strike plus $6 options premium). That is less than $1.50 away from GDX’s recent price. If shares hit the $30 target, then the call option would have $14 of intrinsic value and deliver a gain of more than 130%.

Recommended Trade Setup:

— Buy Market Vectors Gold Miners ETF (NYSE: GDX) Jan 2015 16 Calls at $6 or less
— Set stop-loss at $3
— Set initial price target at $14 for a potential 133% gain in 12.5 months

Alan Knuckman

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Source: ProfitableTrading