Monday, May 31, 2010

Evolution of a Bullish Risk Rocket

Since highlighting gold's breakout in April's Time to Shine post, we've seen the precious metal surge up to $1250 and subsequently fall back to its breakout point. Those familiar with technical analysis 101 know that prior resistance often becomes new support. The price action of GLD over the last month serves as one such example of this basic tenet (click any image to enlarge).
[Source: MachTrader]

To take advantage of last week's textbook bullish retracement pattern, suppose we entered a bullish risk rocket on May 21st by purchasing 100 shares at $115.90 and two June 121 calls for $1.55 apiece.
As mentioned in previous risk rocket discussions, the initial target for the stock is a mere 1 ATR. With last Wednesday's gap we would have been able to sell the stock around $118.50 for a $260 profit. This gain reduces the risk on the two call options from $310 to $50. Traders still aggressively bullish on GLD may opt to simply hold onto the long calls and find comfort in the fact that their remaining risk is a small $50. Those with a less aggressive outlook wanting to further diminish the risk involved may consider rolling the calls into some type of spread. As illustrated in the Decision Tree post, potential choices may include bull call spreads, ratio back spreads, butterflies and condors. For GLD I elected to roll into a bull call spread by selling 2 Jun 124 calls for $.91 apiece.
Due to the $182 credit received from the short calls, our remaining risk is eliminated and we now stand to gain $132 minimum reward. Best case scenario occurs if GLD resides above $124 at June expiration. By expiring in-the-money, our call spread will realize it's full profit potential. Within the decision tree displayed below we are currently in T2. Depending upon how GLD performs over the next few weeks, we may think about making one last adjustment into a butterfly or condor by adding a bear call spread. It really comes down to whether there is sufficient premium in the out-of-the money calls to make it worth our while.
For related posts, readers can check out:
Adjustment Thinking and the Salvation Syndrome
The Sling Shot
Risk Rocket

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