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Define your risks to avoid market noise disruptions

|Includes:SPDR Gold Trust ETF (GLD), SPY, TLT

Gold at $1310, 30-year Treasuries at 3.66% yield and the S&P at $1147.

Seriously can all of these continue to rally?  You betcha.  Can all plummet and wreck your account?  You betcha.

I am going to offer up a KISS concept I often use.  When in doubt, dont trade.  If you must trade, trade small.  If you must "invest" and not sit on cash because its not sexy then KISS.

How can you KISS in this current market?  Define yourself it works wonder like visitng a shrink doctor when you have mental issues. 

What do I mean by defining in terms of investing? 

1st define what your investment style is.

Are you a trader, then trade dont make trades an investment.  Investors, pick your targets based on your fundamentals and stick to them for your tiered entries. 

2nd, once you pick your investment style then define your price targets for your trades or investments both on entries and exits as well as the tier levels for all three.

3rd.  Then trade your plan and stick to it. 

Why did I mention gold, 30-yr and S&P.  All three are broadly tradeable with relatively great liquidity, all feel toppy but can easily continue at warp speed.

So my speciality and fortay is in option trading.  Maybe its not some peoples cup of tea but its a great way to define your risk.  I am going to offer up my opinion on all three on paths they can take by year end.

Gold could easily go to $1500 or $1000.  Yeah broad range right?  At $1310 its getting to the $1500 mark.  Lets use GLD for our example, GLD closed at $127.85.  So lets just say GLD can go to $100 or $150. 

A trader may be defining their risk by having a $2 stop loss or the equivalent of roughly $1250 gold.  Instead of getting bounced around by the stop loss (maybe it hits it by just a penny then sky rocket up) one could simply buy January 2011 $127 calls for $6.10.  Your maximum risk is $6.10 but you dont have to worry about any more.  A simple substitute trade versus being long $128 worth of GLD.  For $6.10 you can participate on an massive upside move in GLD yet face no major downside risk.  Yes there are pitfalls in just buying a call.  Theta will reduce the value to zero if GLD doesnt trade up.  You could consider this a stock substitute trade.  If GLD does trade up to $150, then your returns will be $16.90 / $6.10 or 277% return.  Your maximum risk is the $6.10 you paid or 4.77% of the current stocks value and you dont have to worry about a stop loss getting you out at the wrong point. 

One could also buy a put to guarantee their "exit" point and not have to worry about a stop loss.  Given that put options are relatively cheap on GLD (Jan 2011 $127 puts cost $5.10) it is not a bad way to play it either.  Either way theta will be a problem with either of them.  Plenty of ways to remedy that but all of those remedy make the positions more complex and the concept in KISS.

TLT or 20-year treasury is at $106.02.  How low can interest rates really go?  No one knows, probably really depends on what the government wants them to be.  Yes I know the markets "are" relatively capitalistic but I dont know many firms that will step in front of the government until the rates really reach a level that firms will.  Does 3.66% on the 30-yr represent that?  No.  But I am in the belief that rates will be over 5% on the 30-year Treasury  in the next 30-years but can also see the 30-year Treasury go below a 2.75% yield.

A $105 straddle on TLT on January 2012 options would cost $17.75.  This gives one a dual play on seeing rates continue lower to then "blow" out and go much higher.  My take (I am a trader so I trade short-term but this is a KISS conceptual agrument) is that rates will go lower and then go higher.  One has to actually trade this position.  On a move lower in the rates one should sell out of the $105 calls.  Maybe a move back up to the TLT to the $108-$110 area might be early but could easily occur.  

If this were to occur then sell out of the long $105 calls for a profit and this profit then reduces the costs of the put position.  Then you sit and wait on a move higher in the rates if they do occur.  Either way, given the 52 week range of yield prices, this trade can provide profits on both ends (both profits on teh calls and puts) if properly traded but you have over a year to do so.

SPY is at $114.67.  The market in my opinion can rally back up to this years high around $122.  Not a ton of upside, maybe we could eek out $130.  However the downside is definitely apparent.  Maybe we crack below $100 on the SPY or below $1,000 on the S&P.  I give both ideas even 50% probabilities. 

Call options are rather expensive on SPY.  January 2011 $115 calls cost $5.26.  January $114 puts cost $5.74. 

A KISS concept, a 1:2 put ratio trade on SPY on a strictly Tier 1 of 5 basis.  $114 puts cost $5.74, $107 puts could be sold for $3.38 each.  $5.74 - $3.38 - $3.38 = -$1.02.  The simpliest view of the trade is such.  If the S&P/SPY stays flat or goes up then your profit by year end wold be $1.02.  If the market goes below $107 then your agreeing to be long S&P at $989 or $98.9 SPY.  Remember this is a Tier 1 of 5 entry, your next 4 entries could be at $24 point increments or buys at $74, $50, $26 and $2.  Maximum value at risk would be the $98.9 or your return would be 1.03%.  Better than the 6 month Treasury at .19% yield.  Maximum profitability would be $8.02 ($114-107 @ $107 = $7 + 1.02) / $98.9 = 8.11% return. 

Hopefully this helps to keep people invested in profitable trades or even to initiate new positions.  Profits are never guaranteed but with some hard work and keeping a cool head and KISS positions one can ride out turmoil based on market noise and have defined risk. 

Disclosure: No GLD positions as of writing, no SPY positions as of writing, Butterfly call spreads @ net credit on TLT

Stocks: GLD, SPY, TLT