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« Strong Auction Demand in Greece, Euro Steadies, Dollar Weakens | Main | Gold Prices Move Higher As the European Union Dithers »
Tuesday
Apr132010

OPTIONTRADER: 20% in 46 days, Risk and Leverage

SLV Calls sk options trading

In the latest closed trade from OPTIONTRADER, we made 20.44% in 46 days on $16 Jan-11 SLV calls. As the chart shows, we clearly would have made a greater profit by holding the calls until now, since they have traded as high as $3.00, whereas we were stopped out and sold at $2.18.


However our strategy is not to aim for the maximum reward, but the maximum reward relative to risk. Many people tend to focus too much on the rewards of a trade, without properly assessing, managing and limiting their risk. This is essential in all areas of trading an investment, but particularly to options trading where there is the added risk of time premium decay each day.

The tactics used in this trade aimed to minimize our risk and maximise our reward, therefore as the trade moved into profit, we place a stop order in behind the price to ensure that our profits were locked in as the call increased in value. Our stop order at $2.18 was triggered as silver dropped slightly and the call fell close to $2.00.

Of course there is a part of us that thinks perhaps we should have held out, and would now be sitting on the calls at $2.95 rather than having sold at $2.18. However we look back with no regrets. We have a successful trading strategy and we stick to it. We managed our risk effectively and made a significant profit given the relatively small time period.

One issue that is brought up again and again by investors and traders is leverage, and how to gain the greatest leverage (again with respect to risk) on a given trade. To illustrate the leverage on our SLV trade detailed above, we have graphed the performance of 3 other silver investment vehicles, silver itself, as many choose in be in the physical metal or the ETF, and two of our best performing silver stocks, Pan American Silver (PASS) and Silver Wheaton Corp (SLW).

SLW SLV PAAS sk options trading chart

As you can see our SLV trade was clearly the better place to be over that time period, so our money was right to be invested in those calls than in SLW or PAAS stock or silver itself. Many will quickly point out that options carry a lot more risk than the stocks or metal, but let’s just take a look at the risk picture in more detail.

We purchased the call option at $1.81 with a $16 strike price, expiring in January 2011. When we bought, SLV was around $15.50-$15.00, so our call was out of the money since it gave us the right to buy at $16, a price higher than spot. Therefore if SLV simply stayed below $16 until January, our options would expire worthless. That is clearly a risk, however SLV was $17.81 on the day of expiration we would break even, and anything higher than that would be pure profit, eg if SLV was at $19.00 at expiration our option would be worth $3.00. So the question we asked ourselves was, do we think silver will trade higher than $17.81 by January 2011?

Our answer was a firm yes. So we did not view the risk of the option expiring worthless as very large, and we prepared to hold the calls until expiration if necessary, even if things got volatile. We actually expected silver to make gains a lot sooner than that, therefore once the trade moved into profit, we moved our stops up as detailed above.

Now let us take a looking at the risks of holding a silver mining stock, which many perceive as less risky than holding an option.
-There could be geopolitical instability in the region that the company is mining
-There could be technical troubles with the mine itself
-The deposit may be smaller than expected (or even the same size but the lack of expansion and good new releases causes the stock to drift south)
-Costs of mining could increase harming the company’s profits
-Tax changes in country of operation could harm the company’s bottom line
-Good management could leave, causing investors to lose confidence in the stock
-Exchange rate fluctuations for companies operating in more than one country

These are just some of the potential risks to holding a mining stock, but it is enough for us to say that the call option offers the better return/risk ratio. There are of course some great companies out there who are making a lot of money, and all credit to them. However we would say that the call option is the better way to play a rise in silver, simply since it is more directly linked to the price of silver than stocks which can be affected by a myriad of external factors.

Another thing many investors tend to misunderstand is the variety of options available, and how much risk differs from one to another. It is far crude to brand all options as “too speculative” or “too risky” when there are options that are possibly less risky than stocks in our opinion.

Therefore by making the right selection of options, one can tailor the risk/reward ratio to suit one’s personal preferences, investment objectives, aversion to risk etc. At SK Options Trading we specialise in this, and our premium options trading service OPTIONTRADER offers real time trading signals and updates, delivered directly to you by email in simple readable formats which make them quick and easy to interpret, understand, act on and ultimately, profit from.



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