- Posted by Richard Croft on May 28, 2012 filed in Options Market
You may recall at the end of April (see “Gold Miners Tarnished”) I wrote about the sell-off in gold and more importantly the havoc that could wreak on gold mining stocks.
In that blog I suggested buying the July 20 puts on iShares S&P/TSX Global Gold Index ETF (TSX: XGD, Friday’s close $19.38). At the time XGD was trading at $19.31, which interestingly is generally where it is today. But around the middle of May the sector sold off sharply and XGD traded below $17 for a period with the July 19 puts trading in the $2.50 per share range.
The scenario that occurred with XGD is instructive in terms of how you should manage speculative trades. Make no mistake whenever I talk about buying options (either calls or puts) you have a responsibility to at all times remain vigilant and take profits when they come about.
You should always take action when the price of a short term speculative trade has doubled. Nothing wrong with taking a profit on the entire position or at least, selling half the position to take your money off the table. When engaging in speculative trades it is more about cash management than over the top profits.
In the same blog I also talked about Agnico-Eagle Mines Ltd. (TSX: AEM, Fridays close: $41.02). With this stock I was talked about writing the AEM June 40 puts at $2.40 or better. At the time the stock was trading at $38.70. Writing cash secured puts is a lower risk trade and one that you do not have to exit immediately if things go bad.
Again it is helpful to think about the logic underpinning the trade. You should be thinking about taking possession of the stock at a favorable price. In this example if the AEM 40 puts were assigned you would have, by the June expiration, bought shares of AEM at an average cost of $37.60 per share ($40 strike price less $2.40 premium from the sale of the puts).
If you viewed the short put in the same light as the more speculative put buy, you may have closed the position when AEM fell below $35 in mid-May along with the rest of the sector. At that point you would have suffered a 100% loss on the position.
But if you exited the position early you would have missed the rally off the mid-May bottom. AEM rallied faster and with greater intensity than the overall sector mainly because of the rationale that underpinned the original suggestion; i.e. AEM was generating stronger earnings in a downward cycle. Coming full circle, the AEM June 40 puts are currently trading at $1.30 with an implied volatility of 55%.
If you held onto the position, you could take a profit at current prices or, at a minimum, unwind half the position. I say that because the current price/implied volatility is higher than I would have expected given the time decay and solid rebound in the share price. It makes me question the legitimacy of the recent rally.
When you think about it, options are a discounting mechanism applied to the risks in the current environment. When the options implied volatility is rising, it is often a precursor to a change in direction. Volatility is a two way street and the recent rally may be due for a correction.