Investing in Gold Options

So you own a portfolio of gold stocks and you’re worried about losing some of your gains to the return of a bear market on Wall Street, or a correction in oil prices, or a temporary bounce in the U.S. dollar.

You tell yourself that these things are not fundamentally bearish for gold prices. One of them is even bullish. But you know that gold is probably due for a correction anyway, and any one of these, or other factors, is just as good an excuse as any fundamental when confronting a risk-averse crowd.

What do you do? You could weather the storm. You’re in for the long term, right? The trouble is gold stocks can fall a lot during even a typical correction.

Most everyone already knows that markets do not go straight up. If every dip led to higher and higher highs, nobody would ever lose sleep over it. Trouble is, the company could always screw up, or one of those dips could turn into a bear market. I have seen the conviction behind many buy/hold strategies melt at the tail end of a normal correction, just because it corrected invariably worse than expected.

In my observations, investors are more likely to get bucked off a bull market because one of the corrections discourages them than because they took some profits by selling into strength.

Goldcorp, one of the world’s largest miners today, has already seen three corrections of 40-50% on the way up to $45 from its $3 (split-adjusted) share price back in early 2001. That’s a 15-bagger! And it’s not over. Goldcorp will see a few more like corrections, and maybe one that’s even larger, on its way to $150. Hardly anyone who bought at $3 will still be aboard, and even fewer will sell the top:


However, there are ways to improve your long-term returns and reduce the impact of market volatility on your portfolio without ever having to trade in and out of your shares and risk getting bucked off the bull too early. Options! Options allow investors to take advantage of leverage and limit their risk.

They represent a way to benefit from most of the change in the value of the underlying property or shares without ever having to buy. Due to this leverage, they can sometimes increase hundreds and thousands of percent in the space of a week, or even a day, as in the case of Bear Stearns put options when the stock halved that fateful Friday before last. Consequently, they don’t draw only speculators; they draw gamblers ready to stake the farm on getting rich quick by abusing the available leverage.

But gambling is in the method. If you don’t know what you’re doing, you’re gambling. Otherwise, you are speculating, hedging or investing.

Today, I am going to show you how to “insure” a portfolio of gold stocks emulating the Amex Gold Bugs Index (HUI) against an intermediate correction using a few basic option strategies. “Intermediate” just means like any of the other four-five corrections that are most evident in a chart of the seven-year bull market to date.

They averaged 10-15% prior to 2005, but with the accelerated rallies post-2005, they are more likely to look like the 27% correction in 2006 from now on. A correction in the primary (seven-year) sequence would be more like 40-50% or more, which I’ve judged a low-probability event from these levels.

In any case, the first thing to do is nail down a few scenarios you think are likely. That is, try to quantify the risks. Let me walk you through some scenarios.

If last week’s sell-off is the beginning of an intermediate correction in gold prices, which is possible, gold could fall back into the $700-800 range and/or remain range bound until next year.

The “tape” is telling us this IS the likely scenario. The gold stocks traded up with gold, but they lagged it, as if they were tired. And not all of them participated. Many of the juniors sat out the last $300-400 gain in gold. The breadth of the advance was thus narrow and the leadership extended. And the way gold prices came off their peak is itself often a bearish marker, indicating more of the same to come.

I’m assigning this scenario a 35% likelihood and a 10% chance of something worse. The most likely (55%) scenario, in my outlook, is that the bulls will hold the line at the $850-900 level for a few weeks and then continue their unfinished business — i.e., developing a real top well above the $1,000 barrier.

But that analysis goes beyond the purpose of this article.

If you think the likely scenario is an intermediate correction, or worse, the easiest option strategy is to “write” (or short) a call. Writing calls is effectively the same as shorting them, except that options are contracts representing but a “right,” so the short seller is technically the underwriter of the contract. If the underlying asset goes up, he will have to either buy the calls back higher or deliver the asset(s).

If you don’t own the asset, it’s a naked short, and the theoretical risk is unlimited. If you own the asset, your risk manifests in the form of reducing or limiting your profit on the underlying position. Since we are talking about insuring a portfolio of gold stocks against a correction, we are talking about the latter.

In our hypothetical scenario, with gold falling to $700-800, the HUI might fall to the 350 level, plus or minus 25 points — which is about 90 points (or 20%) below the current level of about 440.

A note of caution: In this example, I am assuming that your portfolio of gold stocks mirrors the HUI; if it does not, you are better off writing those calls on the specifically optionable stocks in your portfolio.

Otherwise, there can be no assurance that your risk will be limited.

Last week’s bid on the Amex Gold Bugs Index (HUI) 375 September 2008 call was around $8,960 per contract — or $89.60 per each hypothetical index share. This means that if the gold share index falls below 375 before the option expires in September, you can pocket that entire amount less commission and time value. You start losing money on your underlying position only if the HUI falls below about 350:

439.05 – 89.60 = 349.45 (or approximately 350)

If the index falls less than expected, say to about 400, you might make between $20-60 points per hypothetical index share, depending on days left to expiry, which would likely cover the correction.

The downside is that gold shares brush this correction off and continue to truck higher, in which case you do not participate in any of those gains until and unless you close out your short call position.

It would not be advisable to buy puts in this situation, because premiums are too high to protect you against an intermediate drop, at least in the index. The September 2008 HUI 435 put was offered at $54 on March 20, which means it would cost you about 13% to protect your portfolio from a 15% correction.

It only makes sense to buy a put to protect your portfolio from a much larger correction. If you thought the gold share averages were in for a nasty 40% or more decline, then it would make sense. Effectively, it would protect your portfolio against any losses that exceeded a 20-25% correction.

The nice thing about options is that they are flexible. There is a myriad of strategies available to suit almost any situation. You could write the September 2008 375 call and buy the September 2008 375 put, which would net about $5,900 per contract and cover most of your downside, but eat into your gains more.

Alternatively, if you’re not so bearish, you could write an out-of-the-money put…

Ed Bugos
March 26, 2008

The Daily Reckoning