Looking for a Threepeat (GLD, BIDU, SLV, GS, VIX)

A couple of dandy trades to report on today, so let’s not waste any time.

Put on your sneakers and get rolling!

adidas

We lead off with an effort launched on the 23rd of September, in a letter called Silver and Gold(man).

We were trading two completely divergent sectors with this one – precious metals and financials. Our thinking was as follows –

“… we’re pairing the two not because there’s some sort of inter-market relationship that obtains between their respective sectors, but because one looks toppy and in need of a trim, while the other appears to have bottomed.”

No magic there. A straightforward overbought/oversold pairing with the iShares Silver Trust (NYSE:SLV) and Goldman Sachs (NYSE:GS) as the objects of our lust.

The long SLV CALLs were closed for $0.25 on October 21st in a letter called Disaster Strikes the Hunter, but the Goldman CALLs we left alone. We felt they’d expire worthless as they still had quite an ascent ahead of them before they came into the money.

And so it was. As of last Friday’s options expiry, our short Goldman 197.50s expired worthless, and we come home with the $0.25 we garnered from the SLV CALLs and another $0.12 from the initial credit spread.

A profit of $0.37 for every pair traded on absolutely nothing up front.

sublime

You said it, sister.

But wait! It gets better!

 

Bravo to the Hunter! On the 7th of October in a letter called Biding Time ‘til the Pause is Over, we initiated a doozy of a trade on Chinese corporate powerhouse, Baidu Inc. (NASDAQ:BIDU), the Google equivalent for a billion and a half Chinese internet users.

The trade still has time to run, but we believe strongly in avoiding unnecessary waits, particularly as we’re up significantly, we’re trading options, and getting too greedy is a sure-fire recipe for a loss.

So how did it go?

 

Well, we worked the trade with three separate components. The first was a short term short PUT that expired worthless last Friday, bagging us the full premium. We sold the October 31st 200 PUT for $3.15 and today it’s all ours.

The second component was a debit spread using a long January 230 CALL that we bought for $11.15 and a short December 250 CALL that we sold for $3.95. All told, the debit on the trade was $4.05 (11.15 – 3.15 – 3.95).

Today the spread components are trading, respectively, for $16.30 and $4.75. Sell the first, buy back the second, and you have a total take of $11.55 (16.30 – 4.75) on an initial outlay of just $4.05. That’s 185% in four weeks, and we defy anybody in the newsletter business to shellac the porpoise to greater gains than those you consistently find here at Options Trader Elite.

porpoise

A Whale of a Trade

With the delighted squeaks of our mascot ringing in our ears, we now move to a new trade for our fellow members.

Here goes –

General Options Trading Principles

We preface the trade with a very brief discourse on volatility.

For those who aren’t aware, a falling stock experiences an increase in ‘implied volatility’, a measure of the estimated future volatility of that security and a key component in setting its options’ prices.

VIX (seen on chart below) is a widely watched gauge of the implied volatility of the S&P 500, and therefore gives us insight into the market’s perception of where stocks are headed in the future.

vix
Of course, the VIX (also known as the market’s ‘fear gauge)’ can also be employed as a contrarian indicator. High readings are generally associated with market bottoms and low reads with market tops.

As the chart above shows, investor fear levels spiked during October’s mid-month decline and have since returned to more neutral levels.

But we want to focus more sharply on the role that volatility plays in options pricing. Because, as you’ll see, it’s very easy to correctly predict a market bottom from a volatility spike, to purchase a CALL option, to have the market rise significantly, and to nevertheless LOSE money on the trade.

How can that be?

 

Well, as mentioned above, the Black Scholes model of options pricing (which bears a very close resemblance to the way options are valued in the real world) relies to a significant degree on implied volatility as one of its many inputs. So as a stock declines in value, and its volatility rises, the price for that security’s options will increase dramatically, reaching a peak just as the greatest selling occurs at the stock’s bottom.

So for those who correctly call the bottom, and wish to speculate on the subsequent rise with a CALL option – they face a strong headwind. Why? Because prices may be so outlandish that as the stock subsequently rises, and volatility diminishes, that same CALL option may be worth LESS than what they originally spent – even as the stock has soared heavenward!

For that reason, it’s far safer to speculate using long PUTs before an expected decline than long CALLs before an expected rise. In so doing, one benefits from the ensuing expansion of volatility (and price). At bottoms, of course, it’s more prudent (though far scarier) to sell volatility via PUTs, thereby taking advantage of temporarily elevated prices.

bears

Yes…

Among other things.

We like the structure of the Baidu trade above, so we’re replicating it here for the precious metals – only in reverse, because we expect them to decline.

Take a look at the last six months trade for the SPDR Gold Trust (NYSE:GLD).

gld
Last Thursday’s dump below long-term support at $114 (red line) was an all-out sell signal, as far as we’re concerned. Even if we see some play in the current range, the intermediate-term indications for gold are all bearish, to be sure.

For starters, there’s no volume, aside from a one-day spike seen in the red circle. And RSI (in black) still could dump from here before registering a deeply oversold sub-20 read that pulls in some buyers.

Outside of that, there’s not much good to report.

We’re going down.

We’ve indicated on the chart where we’re selling CALLs for premium (in green). In addition to that, we’re also initiating a calendar PUT spread.

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[mepr-rule id=”204″ ifallowed=”show” description=“options_trader_elite_members_only”]

Options Trader Elite recommends you consider 1) closing your BIDU spread, as indicated above, and 2) selling the GLD December 121 CALL for $0.56 and the GLD February 100 PUT for $0.98, while buying the GLD June 100 PUT for $2.24. Total debit is $0.70 per trio traded.[/mepr-rule]

[mepr-rule id=”988″ ifallowed=”show” description=”executive_lounge_members_only”]

Options Trader Elite recommends you consider 1) closing your BIDU spread, as indicated above, and 2) selling the GLD December 121 CALL for $0.56 and the GLD February 100 PUT for $0.98, while buying the GLD June 100 PUT for $2.24. Total debit is $0.70 per trio traded.[/mepr-rule]

With love of the hunt,

Hugh L. O’Haynew, Senior Analyst, Normandy Research

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