Gold Miners: A Bearish Hedge For Chickens (GDX, GDXJ)

You might have noticed that gold’s upward momentum has been blunted recently. Last month, two attempts to take out the November high failed, leaving prices languishing.

For holders of gold mining stocks, times are even tougher, especially the early-stage companies populating the Market Vectors Junior Gold Miners ETF (NYSE:GDXJ). The GDXJ portfolio gained 54.7 percent in 2010, compared to bullion’s 29.8 percent rise, but now mining stocks are falling at twice gold’s rate of descent.

The relative strength of junior miners, along with that of the established producers as represented by the Market Vectors Gold Miners ETF (NYSE:GDX), peaked in early December:

Mining Stocks’ Relative Strength Vs. Gold

Mining Stocks’ Relative Strength Vs. Gold

The miners’ weakness has some investors, especially latecomers, wondering how much downside is left in the current market. With GDXJ now trading at the $38 level, down from its peak near $45, serious damage could be wrought if market momentum takes the fund below the $35 level:

Market Vectors Junior Gold Miners 

The present weakness could be temporary—a pause before another leg up (for a possible scenario after that leg, see “Is Gold Nearing A Bubble?“). Or it could be the vanguard of a secular change.

Worried bulls now ask whether it’s time to bail from the market and wait to re-enter until the weakness subsides, or to instead just gut it out and stand pat.

But an alternative strategy—options—allows investors to remain in the market, thereby avoiding re-entry risk, while hedging against further damage. It’s like taking out an insurance policy on your investment.

The most obvious approach would be the purchase of a put, which is a contract that fixes a guaranteed sale price for the underlying shares. For example, a May $37 put could be purchased for $3 a share (that’s a total of $300, since each contract covers 100 shares). That grants the shareholder the right, but not the obligation, to sell GDXJ at $37, regardless of its market price, until the contract’s expiry on May 20.

If an investor bought his shares near the top of the current market—say, at $44—the maximum net loss would be $10 a share, even if GDXJ shares swoon deeply. That loss is calculated as the difference between the GDXJ shares’ cost and the put’s exercise price ($44 – $37 = $7), then adding the cost of the option contract ($3).

If GDXJ’s price instead stabilizes or begins to rise, the insurance can be lifted by selling the put for its current market value. In that case, the maximum opportunity cost is $3 per share, although it could be less.

Say, for example, the fund’s price trend reverses, lifting GDXJ to $43. Suppose at that time, the put could be sold for $1 a share. That would make the investor’s cost base for his GDXJ shares $46—or the sum of the original $44 purchase price and the $2 net loss on the put.

Containing Insurance Costs

But a $3 deductible may be a little rich for an investor who figures on a smallish downside potential for GDXJ. He may wish to reduce his insurance cost by selecting a contract with an exercise price further “out of the money.” A $36 put, for instance, might go for $2.75 a share, while a $35 contract may be offered for $2.45. The trade-off for selecting a lower strike, or exercise, price is a higher deductible.

Buying the $36 put would increase the investor’s self-insurance contribution to as much as $10.75 ($44 – $36 = $8, plus the net cost of the put).

Alternatively, the investor can opt for “premium financing,” by purchasing the expensive $37 put and subsidizing its cost with a short sale of the $36 contract. The investor’s net insurance premium would then fall to 25 cents a share ($3 spent for the $37 put and $2.75 collected for the sale of the $36 option).

But while the premium cost drops, so too does the extent of the coverage. The short put premium mitigates the cost of the strategy but also sets a ceiling on its return.

If, for instance, GDXJ tumbles to $30 a share, the $37 put would be $7 “in the money,” while the short put would be intrinsically worth $6. That $1 differential could be captured by offsetting the contracts (selling the $37 put and buying back the $36 put) or through the exercise and assignment of the options. In either case, the maximum net return for the insurance cover would be 75 cents a share ($1 difference in intrinsic value less a 25-cent net cost).

Using the $35 put in the insurance package costs less and offers a wider return spectrum. At a $30 GDXJ price level, the payout would be $2. Adjusting that for the 55-cent net cost of the spread ($3 – $2.45) yields a $1.45 return.

Breaking Even

Thus insured, GDXJ’s nominal breakeven price is the sum of the fund shares’ cost ($44) and the net debit paid for the spread (55 cents), or $44.55:

GDXJ Priceat Expiry Gain/Losson GDXJ Gain/Losson 37 Put Gain/LossOn 35 Put  Net
52.00 8.00 -3.00 2.45 7.45
46.00 2.00 -3.00 2.45 1.45
44.55 0.55 -3.00 2.45 0
40.00 -4.00 -3.00 2.45 -4.55
36.00 -8.00 -2.00 2.45 -7.55
32.00 -12.00 2.00 -0.55 -10.55
30.00 -14.00 4.00 -2.55 -12.55


As you can see, the hedged position still has unlimited profit potential on the upside. Its gain is tempered only by the cost of the insurance cover, or 55 cents.

On the other hand, the package offers some insulation from downside losses. But here you get what you pay for. Cheaper insurance yields more modest protection. Other spread combinations should be investigated to determine if they offer better cost/protection ratios.

Written by Brad Zigler From Hard Assets Investor (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.

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