Option Investor
Educational Article

News Flash! LEAPS Editor Bitten by Gold Bug

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By Mark Phillips

The men in the white coats haven't shown up to haul me away in the wake of Sunday's new LEAPS Watchlist Plays, so perhaps the idea of buying into a Gold stock isn't so crazy after all. The basic premise is that the Gold and Silver index (XAU.X) has been on a steady recovery path since tracing a solid double-bottom in November/December of last year near the $42 level. As the economy has continued to worsen, more investors are apparently taking a liking to the defensive nature of this sector.

After the sharp rally in April and May, helped along by a spike in the price of the yellow metal, the XAU retraced right to its gently ascending trendline near $51 in early July before beginning another upward leg. Confirming the fledgling rally is the weekly Stochastics oscillator, which is just emerging from oversold territory with a brand new bullish crossover of the fast (blue) line over the slow (red).

Contrary to the adrenaline-spiked and irregular moves in the Technology sector, this looked to me like a solid trend that could provide some steady, if sedate profits. Of course, we don't have any LEAPS available on the XAU, so I went hunting for LEAP-able mining stocks that seemed to have a good correlation with the XAU.

The first of the many charts that I pulled up was Barrick Gold (NYSE:ABX) and the resemblance to the XAU was uncanny. To top it all off, the stock had LEAPS available with cheap premiums and some decent open interest. Look at the ABX chart below, and you can see the strong correlation. This allows us to play a major market trend, without having to incur either the expense or the lack of liquidity of trading the index.

The weekly Stochastics indicates that we are catching this move near its beginning, and the fact that ABX is continuing to follow the ascending trendline will give us a good measure of the health of the stock as times marches by.

Drilling down to the daily chart, we can see that the current rally is getting close to running out of steam. What we will want to see is the stock retrace back near the $14.25 level before we initiate our LEAP position. Ideally, that will coincide with the daily Stochastics oscillator dipping into oversold and then beginning to emerge; similar to the picture we now see on the weekly chart. What that means is that we aren't even close to an entry as of this writing. But we have a clear idea of what to target and will be able to recognize it when it materializes in the weeks ahead.

That is only stage one of our trade setup. Now that we have our targeted security and a defined entry point, we need to decide how we will manage the play after we take a position. We can play it nice and easy, buying our LEAP and sitting on the position, but that's not the focus of our discussions here on Wednesdays. We're here to learn about writing Covered Calls against our LEAP, right?

If we were just going to buy the LEAP and hold it, then the $15 strike would probably be more than sufficient to allow us a good mix of high delta and high leverage (a big advantage of LEAPS). But if we are going to write front-month calls against the LEAP, then there is a distinct advantage to buying a lower strike LEAP. That gives us more flexibility in the selection of the short-term call to sell, especially early in the play, before our LEAP has begun to appreciate very much.

Recall from my article Fine Points of LEAPS Strike Selection that I prefer to buy as much time as is available when I intend to write covered calls. This minimizes my monthly carrying cost on the LEAP and allows me more time to profit from the play after I have reduced my cost basis to zero. So I'll be targeting the 2004 $10 LEAP (Symbol:LBX-AB) for the long leg of the trade. I estimate the actual cost of this LEAP when our entry target is achieved will be in the $6.00-6.25 range. That means that we only have to take in $6 in premium before we have the LEAP for free. And we have up to 29 months in which to take in that premium. After that, any additional premium we receive from selling calls is pure profit, added to the appreciation of our LEAP.

Judging by current front-month call premiums, each time we sell a call, the premium we take in will likely be less than $1 as we need to be careful to prevent our sold call from expiring in the money. As I have covered before, that is how LEAPS covered calls differ from equity covered calls -- we never want to have our sold call expire in the money.

Of course with such cheap option premiums, we need to pay attention to commission costs, and this trade will clearly become more favorable if we are trading more than one contract. Multiple contracts will reduce the commission costs per contract to a level where that becomes a less significant factor. Just make sure when deciding on the size of your own trades to abide by good money management rules, keeping the size of your trade in that zone where you are not exposed to undue amounts of risk in a single trade.

My intention in profiling this trade in detail is primarily to give you another real-world example of how the LEAPS Covered Call example works. The primary goal is education, and nothing would make me happier than to hear success stories from you after you have found your own trades employing this strategy and brought them to successful conclusions. But for now, I'm hoping I can provide a clear roadmap allowing each of you to see the trade develop in detail, removing the mystery of the many potential "what if" scenarios. Follow along as you see fit, either watching from afar or following my lead on paper or with real money. Just remember that the education you receive should be far more valuable in the long run than any real profits achieved in this one trade.

Stay Tuned!

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