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LEAP Spread Trading
The Smart Profits Report: Issue #298
Friday, April 7, 2006
LEAP Spread Trading: Gold’s Hot And It’s Time To “Spread” Out Your Fortune…
By Karim Rahemtulla
Chairman, Mt. Vernon Research, Mt. Vernon Research
It’s no longer a secret that metal stocks have been going through the roof. Gold futures reached $600 yesterday, a huge milestone. And we have been there to enjoy the gains all the way up, with Goldcorp, Silver Wheaton, Couer D’Alene, Kinross and Bema, to name a few.
But with these gems approaching gains not seen in metals since the early 1980s, is now a good time to get in on the festivities? The outlook for metals is strong. Fundamentals are good, technicals are where they should be and there’s ample marketplace excitement.
However, as in any hot market, prudent investors should pay close attention. There are several ways to put the odds in your favor, like using LEAP spread trades and trailing stops, just in case there is a meltdown. Let’s take a look…
How to Avoid A Steep Market Correction
Here are two things you should consider immediately to protect your investment and continue making money from this run without taking undue risk.
- Begin by using trailing stops on your positions. Choose a number that you’re comfortable with, whether it’s 10%, 20% or more. Monitor your positions and place mental stops each day. If a position falls to your predetermined level, it is time to sell. In this small but disciplined way you are preserving your profits and marking the price from higher levels. Precious metals stocks tend to be more volatile. So, you might want to adjust your trailing stop accordingly.
- In this strong market for metals, you should start using spread trades. By definition, they offer you insurance against huge swings that can wipe our your profits. That’s because you buy one option at a specific strike price and sell another option at a higher strike price against your initial buy. When using LEAP options you have time on your side, a year or more.
Why Enter A Spread & Which One To Choose?
Let’s say you like Goldcorp (NYSE: GG). It’s trading at about $30 a share right now. The options are very pricey, as is the stock. So you can either risk a lot of money by buying the stock or the option, or you can mitigate the dollars at risk by initiating a spread.
Many options traders will say, “yeah, but doing so limits my upside.” To which I say, “yes, that’s true. But it also may be limiting your downside” Besides, this is just one part of an overall investment strategy. In other words, you are not precluded from owning the shares or options in another trade. The spread merely helps you to diversify your dollar risk.
Back to Goldcorp. You would enter a BULL SPREAD if you think that the shares are going higher, but you don’t want to risk a bundle. So, you need to set a target price. Let’s suppose that $40 is your target. That would net a $10 gain on the shares. However, you’d have $30 at risk.
An Example of a LEAP Spread Trade
Using a hypothetical example, if you use a spread, you could buy a one-year LEAP option with a $30 strike for $5. Against this position you would sell the $40 calls and receive back $2. Your cost is now $3. That is your at-risk capital, not $30. If the shares close at $40 or higher, you would make $7 on your $3 investment ($40 minus $30 minus $3 = $7.) That would more than double your money. More importantly, you would have taken a prudent position by reducing your dollars at risk.
Some investors might feel just as comfortable using a trailing stop. The device would lower their dollars at risk in the stock position. But it would not be as effective as the spread. Here’s why…
Let’s suppose that Goldcorp was trading at $30 and you were using a 20% trailing stop. If that level were breached, you would lose $6 per share. By using a spread your loss would be cut in half, to just $3. As I said before by using LEAPS, you have time on your side - a year or more to accomplish your goal.
So, the next time you take a leap of faith with stocks, make sure that you’ve covered all your options.
Good Trading,
Karim
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Today’s Smart Profits Cribsheet
- I cover a fundamental investing technique that can make a tremendous difference in your results. Here are two quick rules before you click through to the full story: 1) There is no sure thing in investing; and 2) don’t forget rule #1. Check out Smart Profits #249, Position Sizing: The Most Powerful Investment Concept.
- Check out the Smart Profits Glossary for definitions of words like “LEAP” or “spread trade” found in today’s article.
Related Articles:
- Bull Spreads: Bagging a 66% Return on Lexar
- LEAP Options: The Intel Bargain & A Potential 566% Return
- Trailing Stops: How to Give Your Options Room to Grow
