First things first, for those who don’t
already receive these commentaries by e-mail: If you’d like to be
entered in a weekly drawing to win a three-month subscription to Rick’s
Picks worth $106, click here. What do paying
subscribers get that lurkers don’t? Plenty. Yesterday, for instance,
they were advised to cover half of a bullish position we’d staked out
in GDXJ, a vehicle popular with the gold crowd that tracks junior mining
stocks. We paid an average 1.85 for some August near-the-money call options,
but because the stock has been strong this week, we were able to exit half of
them yesterday for 2.25, a nickel off the high. The implied 40-cent profit
has effectively reduced the costs basis of the calls we still hold to 1.45.
Considering that the options have more than four months till expiration, odds
of making a profit look pretty good.
Ordinarily, the odds are horrendous for retail
customers who simply buy puts or calls based on hunches. How bad are the
odds? If it’s a bearish hunch your
playing, you’ve got a better chance of making money by matching three
numbers on a lotto ticket. I’ve been trading options for nearly 40
years, twelve of them on an exchange floor, and have yet to meet a single person
who has made money on put options over time. The odds aren’t much
better for buy-and-hold call buyers, either. All options are “wasting
assets” because their value decreases as their expiration date draws
near. Because of this, options positions must be “worked” to
produce a profit.
The Option ‘Sweet Spot’
One way we might work our August call position
is to sell other calls against it. For example, if the stock continues to
rally, we might be able to sell August 25 calls for 0.45 apiece. That would
give us a bullish “vertical calendar spread” on which it would be
very difficult to lose money. The best outcome we could hope for would be for
GDXJ, which settled yesterday at 23.80, to be trading just below 25 when the
April options expire next Friday. We would simply pocket the 0.45 premium,
further reducing the effective cost basis of our August calls to 1.00.
Capturing the “juice” in an option that has just a week or two
left is the sweet spot of option trading. Near-the-money options are typically
at their most overvalued just before they die.
Ideally, we would repeat this tactic,
shorting, in successive months, May calls, then Junes, and finally Julys. If
GDXJ were to stagnate or move steadily higher between now and August,
it’s conceivable that our “covered” (as opposed to naked)
sales of soon-to-expire calls would more than offset the 1.85 we originally
paid for the “Auggies”. In the
meantime, our “edge” would have come, simply, from having bought
the August calls at the right moment, when GDXJ was bottoming last week.
Granted, there’s always a chance the stock could crash through the
recent low. But it would have to fall pretty hard to turn our August calls
into losers. With a little more work, though, we may be able to reduce their
costs basis to less than zero, making a loss impossible. Subscribe and
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