Gold's July 22 push above $1,300 signaled a technical price bottom in the distressed metal. An extreme low at $1,182 in June marked a drop of $600 from the $1,800 2012 trading range top.
Bullish divergence suggests a real base as the U.S. dollar made multi-year highs in July, and gold failed to make new lows. Continued dollar unwinding is supportive of gold and commodity assets.
SPDR Gold Shares (GLD), the largest physically backed gold exchange-traded fund (ETF), has fallen just over 22% year-to-date. Market Vectors Gold Miners ETF (GDX) has been hit even harder, with a 45% decline year-to-date -- more than double the loss in GLD.
A GDX long call option can provide the staying power in a potential larger trend extension. More importantly, the maximum risk is the premium paid for buying the option.
One major advantage of using long call options 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.
Simply put, 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 an 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 at about $25.40 at the time of this writing, an in-the-money $20 strike call option currently has $5.40 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 80.
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 March 2014 20 Calls at $7 or less.
A close below $20 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-loss, the maximum loss is still limited to the $700 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2014 options give the bull trend almost six months to develop.
This trade breaks even at $27 ($20 strike plus $7 options premium). That is less than $2 above GDX's current price. If shares rally back to the midpoint resistance target at $39, then the call options would have $19 of intrinsic value and deliver a gain of more than 170%.
Recommended Trade Setup:
-- Buy GDX Jan 2014 20 Calls at $7 or less
-- Set stop-loss at $3.50
-- Set initial price target at $19 for a potential 171% gain in 7.5 months