Trade Review: Reversal Play on GLD
07/19/2013 8:00 am EST
You will have better results if you invest your time in tracking specific stocks or ETFs for trades, because you will be familiar with their volatility and price movement trends, advises Michael Thomsett of ThomsettOptions.com.
At the time the trade was opened, GLD was trading at $119.17, up 0.89 from the previous close. I had been avoiding this one because of the recent steep price decline, a troubling sign without any end in sight, and without any clear reversal signals—until this chart developed. It made me think a rebound was going to occur.
The chart shows what I considered substantial reversal indicators and confirmation. The two big downward price gaps indicate a too-rapid price decline. Over recent months, this repetitive gapping was not seen, at least not since mid-April. But there is more confirmation. The oscillator relative strength index (RSI) moved into oversold territory for the first time in two months. Finally, the bullish harami cross highlighted on the chart told me the price was ready for a move upward.
That morning I bought 3 JUL 120 calls @ 2.64 and spent $792.
The following day I closed the position. I took a profit of $222 or 28% in one day. A one-day profit could have been greater by holding on longer, but at the time my thinking was to take profits when they were available. Double-digits in one day? I strongly suggest anyone do this and don’t worry about what might develop in the near future. My rationale was that the reversal and confirmation signals gave me good timing for the trade; and in the short term, this was true.
Questions for you:
- Was it wise to close this position in only one day?
- Would you have opened this position at all, considering long call risks in volatile issues?
- Are there alternative strategies you would have been more likely to use instead?
- Would you have closed at this point, or perhaps closed only one of the two options?
The question of risk has to be addressed in trades like this, without fail. Long calls are always risky because time value evaporates whether the stock moves or not; so you’re at a disadvantage with any long option. This is why I prefer the quick in-and-out swing trade using long options, and only when I can find strong reversal and confirmation.
Do you agree? In any analysis of an options trade, all traders should restrict themselves to actions appropriate for their risk tolerance, so this is the central question. I think too many traders enter trades impulsively without also thinking about whether or not the risk level is acceptable.
Why two options? Why not one, or five, or even ten? Part of the answer is the amount of cash involved; I don’t like to risk too much, and going for a very big number would have been both greedy and more risky. But this is a virtual portfolio, so I am also motivated by the desire to keep it educational. The number of contracts you select should be based on your personal preference and risk tolerance. Some points about risk worth remembering:
- Multiple contracts reduce the trading costs per option.
- With more than one or two open positions, you can close partially to take profits while letting the remainder ride.
- The decision should be based on risk spreading. In a swing trading program, it makes sense to keep the dollar level about the same among many trades, because you are not going to get 100% profits. Why risk a series of small profits on one reckless large trade?
- The use of long calls is only one example of the strategic possibilities here. You might prefer a hedged position like a spread, strangle, or even a backspread.
The choice of GLD is another question worth considering. Why not use a stock rather than this volatile ETF? I do prefer underlyings of stock for most of my trades, but GLD has been a favorite trade for me in the past—partly due to its volatility. Options traders like volatile underlying issues even though risks are higher. You get faster price movement with volatile stocks or ETFs. This means profits can happen rapidly, like in one day in this case. But just as profits can accumulate quickly, so can losses. So it’s a toss-up between opportunity and risk. This is a reality every options trader lives with and cannot avoid.
Are there other stocks or ETFs that would work as well or better? Yes, there probably are. I have been tracking GLD for months waiting for this opportunity, which brings up one final point: You are going to have a better result if you invest your time in tracking specific stocks or ETFs for trades, because you will then be familiar with the volatility and price movement trends.
By Michael Thomsett of ThomsettOptions.com