Bullish or bearish you need to get risk/reward right

February 6, 2014 04:59 AM

With the Federal Reserve  electing to taper for a second month in a row and emerging markets on the brink of crisis gold markets have come back into focus. Buyers have come into the market in 2014 driving the price of the precious metal up nearly 5% amidst emerging market concerns and the worst January for U.S. equities in years. With all of the uncertainty in the market traders may be looking for safe haven plays in metals.  Gold has been relatively volatile over that period so traders looking for opportunity must be mindful of their reward to risk setups.  In times of increased volatility a trader must widen their stops thus increasing the levels of risk they must assume when taking a trade. Options on futures can help a trader manage risk by allowing them to set up well defined risk vs. reward setups. An options trader also benefits from not having to consider stops, as options offer natural risk management as the price of an option can never be less than zero.

Looking at examples of both bullish and bearish setups in gold we can see that options offer a trader superior risk management and better reward to risk ratios. Looking at April options we can calculate implied upside and downside closes on expiration. Using the price of the at-the-money straddle we can then center an options strategy on these targets. Calculating targets this way works better than technical methods used to develop price targets.  With futures trading around $1,255, the April 1255 straddle is trading at 58.80. Using this straddle price we can calculate implied closes of $1,313.80 and 1198.20. Using these targets we can now set up options trades.

Bullish Setup: Trade: Buy the GC Apr 1300-1310 Call Spread for $2.40 Risk: $240 per one-lot Reward: $760 per one-lot Breakeven: $1302.40

This trade sets up for a better than 3-1 reward to risk ratio and has a well-defined downside. A trader is also kept in this trade without risk of being stopped out.

Bearish Setup: Trade: Buy the GC Apr 1210-1200 Put Spread for $2.20 Risk: $220 per one-lot Reward: $780 per one-lot Breakeven: $1207.80

This trade also sets up for a great reward to risk ratio and allows a trader to be short without a stop. This trade also has a very well defined downside.  

Whether bullish or bearish the potential for higher volatility can make every trade a loser regardless of whether you are eventually proven right. That is why having defined risk parameters that without costly stop slippage is necessary to manage volatility.  

About the Author

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.