Bailing Out Of Gold Miners (GDX, GDXJ, KGC, NEM)

Earlier this week, we pondered the implications of company officers buying a certain junior mining stock (“Insiders Buy A Gold Junior. Should You?“).

The article featured a chart showing the relative performance of mining stocks—collectively represented by the Market Vectors Gold Miners ETF (NYSE:GDX) and the Market Vectors Junior Gold Miners ETF (NYSE:GDXJ)—to gold itself.

Gold Miners’ Relative Strength Vs. Gold

Gold Miners’ Relative Strength Vs. Gold

As the chart indicates, juniors are slumping, but established producers have been positively—or, more accurately, negatively—languid compared with bullion. Just ask an owner of Kinross Gold Corp. (NYSE:KGC) or Newmont Mining Corp. (NYSE:NEM), which are both top-10 holdings of the GDX portfolio. Kinross is down 17.7 percent this year alone, while Newmont’s off 10.9 percent.

Long-term owners of these stocks have piggybacked on bullion’s good fortunes, but more recent acquirers have been disappointed with the issues’ recent performance. For many, an allocation to the miners may now seem like a poor choice. Some may hope to just break even on their investment and look for better prospects elsewhere.

Gold’s current buoyancy sparks new hope for a break-even move in the producers. After all, Kinross’ and Newmont’s stock prices are fairly well correlated to bullion—at 64 percent and 67 percent, respectively.

Stockholders looking to bail from an underwater position without a loss must either hope the stocks rally to their purchase price or attempt to lower their break-even points by “averaging down”; that is, by buying additional shares at the now-lower market price.

Adding shares to a losing position, however, exposes the investor to more, not less, risk, as capital must be funneled from other allocations.

Luckily, the option market offers a strategy that allows an investor to lower his/her break-even point without adding any money. It’s called a call ratio spread.

“Whoa!” I hear you say. “Ratio spreads? Options? Way too complicated!”

It’s really not. Give me a minute to explain.

Let’s say you bought 100 shares of Kinross—now trading at $15.60 per share—at $18.00 earlier this year. You’re presently $2.40, or 15.3 percent, away from breaking even and now think your assets could be employed more profitably elsewhere.

Kinross Gold Corp. Vs. Gold Bullion

Kinross Gold Corp. Vs. Gold Bullion

If we look at the option market, we’d see a KGC May $16 call is now offered at 80 cents a share, while calls with a $17 exercise price can be sold for 40 cents a share.

Calls, of course, convey the right—but not the obligation—to purchase the underlying stock at the strike, or exercise, price. Purchasing the $16 call means you can buy 100 shares of Kinross anytime before the call’s May expiration. Selling calls, on the other hand, obligates you to deliver 200 KGC at the $17 strike price, should the buyer choose to exercise his/her right.

You could buy the $16 option and finance its purchase with the simultaneous short sale of two $17 calls. Doing so, you’d overlay a call spread on your stock position with no capital or margin commitment.

But to what end?

Well, let’s look at a couple of scenarios.

Suppose KGC advances to $17 in May. Your stock would still be $1 underwater. Your long call, assuming the market’s wrung out all of its time value—likely as expiration approaches—would be worth $1 a share. The $18 calls would be out of the money, making them worthless.

You’d lose $1 on the stock, but make a buck on the long call. You’re now breaking even at $17, a dollar better than your original basis. Thusly spread, you’re only asking KGC to rise $1.40, or 9 percent, to bail you out.

That’s an important point. You still need the stock to rise to lift you of your predicament. Just not as much as before.

And you have to be willing to lose the stock should a strong rally develop. Suppose, for example, Kinross climbs to $20. You’d be $2 to the positive on your shares, and your long call would be worth at least $4, but those two short calls would each be $3 in the money. The value of your assets—your long stock and long call—would offset your short call liabilities.

In all likelihood, though, you’d probably be assigned on the short calls. By exercising their contract rights, the call owners would force you to deliver stock. That’s not a problem, because neither of the two calls you sold were naked. One is covered by your stock ownership; the other by the $16 call you purchased. At this point, you could deliver your long stock and exercise your long call to obtain another 100 shares.

It’s for that reason that no margin is required, though the trade must still be done inside a margin account.

There’s still the downside to consider. Losses remain open-ended below the $17 break-even point, so this position doesn’t provide hedge protection. You have to possess faith in the stock’s near-term upside for this trade to make sense.

KGC

At Expiry

Gain/Loss

on Stock

Value of

$16 Call

Value of

$17 Calls

Net

Gain/Loss

$20 $2 $4 -$3 x 2 0
$19 $1 $3 -$2 x 2 0
$18 0 $2 -$1 x 2 0
$17 -$1 $1 0 0
$16 -$2 0 0 -$2
$15 -$3 0 0 -$3

 

With gold’s price currently reaching new highs, owners of laggard gold producers must now look to their stocks’ bullion correlations to determine just how much faith they can reasonably muster.

Written by Brad Zigler From Hard Assets Investor

HardAssetsInvestor.com (HAI) is a research-oriented Web site devoted to sharing ideas about hard assets investing. The site has been developed as an educational resource for both individual and institutional investors interested in learning more about commodity equities, commodity futures and gold (the three major components of the hard assets marketplace). The site will focus on hard assets investing without endorsing or recommending any particular investment product.

HARDASSETSINVESTOR.com

This article is being distributed courtesy of www.HardAssetsInvestor.com. Copyright HardAssetsInvestor.com All Rights Reserved.


Leave a Reply

Your email address will not be published. Required fields are marked *