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Options Theory: Trading a Gold Stock

April 1, 2021

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Monday’s Tales of a Technician showed how I used top-down analysis in the gold space to find Franco-Nevada. Its relative strength and leadership were obvious. And, I’m happy to report, the stock is breaking out.

Let’s use today’s Options Theory blog to map out two different trade ideas. This will illustrate strategy selection and the trade-offs for using one system over another.

The Chart

FNV recently returned to the north side of its 50-day moving average amid heavy accumulation. Since then, a high base formed that ultimately broke out this week. I’d use the 200-day moving average at $135 as the next logical target.

$FNV chart

How to Play?

The stock is $127.50 and has an implied volatility rank of ZERO. For the rookie, that means that stock options on FNV are the cheapest they’ve been for the past year.

I’d peg my bias at +1 or +2. It’s really hard to have a +3 bias on FNV when gold is still in a downtrend (see GLD) and its industry (see GDX) is below the 50-day moving average.

If I consult my strategy matrix (learn more about it here). I see that my options are either a poor boy’s covered call (aka bull call diagonal) or a bull call vertical.

Strategy Matrix

The biggest determinant for me in choosing between the two is the capital requirement. The poor boy is more expensive than the bull call vertical. This is where account size, existing positions, and preference enter the equation. In this situation, I think both trades work.

Let’s build one of each.

Bull Call Vertical

The bull call spread consists of buying a lower strike call and selling a higher strike call in the same expiration month. The risk is limited to your original purchase price and the reward is limited to the spread width minus the cost.

With FNV near $127.50, I could buy the May $125/$135 bull call for $4.15. The max loss is $4.15 and will be lost if the stock sits below $125 at expiration. The max gain is $5.85 but requires FNV to rise above $135 by expiration.

If I didn’t want to risk the entire $4.15, I could place a stop loss below the low of the high base pattern near $121. That would shrink the loss closer to $1.70.

$FNV bull call vertical risk graph

Poor Boy’s Covered Call

The poor boy’s covered call involves buying a longer-term ITM call (to act as a stock substitute) and then selling a short-term OTM call (typically the same strike you would sell if you were building a traditional covered call).

Suppose we purchased the July $120 call (68 delta) while selling the May $135 call (34 delta) against it. The net debit is $10.05, or more than double the cost of the bull call vertical.

That $10 is the max loss, but a stop near the 50-day moving average ($119 – I like looser stop losses on covered call plays) would reduce the risk to around $3.20.

The max gain sits north of $6 if FNV rises beyond $135 by expiration.

$FNV poor boys covered call risk graph

One key difference between the two is their respective theta values. The bull call vertical starts out theta negative. If the stock doesn’t rise, you don’t profit. That’s why it’s more of a DELTA play.

In contrast, the poor boy starts out positive theta. Even if the stock doesn’t budge, you still score a profit.

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