Spinning Straw Trades Into Gold – Part 2

By Phil of Phil's Stock World 

Thank you Mr. Zoellick!

It's been a long time (March 2009) since we've been on the gold bandwagon, when I said to Members: "I still think we should get a correction in gold back to $875 (no longer $850 as the trendline has been yanked up) but we're not hedging gold because we are worried it will hit $1,000, we are hedging because we are worried it will hit $2,000. That means that the difference between buying gold at $850 or $950 is not a big enough deal to stay completely out of it now. We would LIKE to be in the 2011 $70 calls for $20."  

We didn't quite get $20 but gold hit our entry target of Gold $875 in April and we had a brilliant rolling plan (see original post) that put us in at the right net price and those calls are now $67.72, up 238% as gold crosses $1,400 (up 64%).  This is the beauty of using options for a hedge.  Three ounces of gold were $850 each or $2,550 and you made $1,650 if you bought it then but 1 contract of the (GLD) $70s cost $2,000 and is now worth $6,772, a profit of $4,772 or THREE TIMES more than the profit on gold with 20% less money committed.  

Do you see why, at PSW, we love options, now?  In fact, we featured an (ABX) option play in our Stock World Weekly newsletter this weekend which has already gone into the money after just 24 hours.   Are you interested in learning how to trade with options?  Well, let's go then!

 - strong positive correlation
 - moderate positive correlation
 - negligible correlation
 - moderate negative correlation
 - strong negative correlation

First of all, let's get a little boring. It's important to understand WHY you are buying gold. Gold is a hedge, not an investment. Gold has no real value other than what other people think it's worth at any given time so we don't take it too seriously but it's a VERY POWERFUL hedge. FX Boot Camp does an excellent thing called a Correlation Matrix (chart on left), which shows you how gold performs relative to other asset classes. The chart key is as follows: 

• DX = December 2010 U.S. Dollar Index contract
• S&P 500 = December 2010 S&P 500 Index e-mini contract
• Gold = December 2010 Comex Gold contract
• 10yr T-note = December 2010 10-year U.S. T-note contract
• Oil = December 2010 Light Sweet Crude Oil 

You can see that gold is mainly a negatively correlated trade against the dollar - it's there to protect your cash!  You stocks are not cash, your TBills are not cash, your other commodities are not cash so don't make the mistake of over-protecting yourself because gold will crash with the markets - that's something a lot of people did not realize in our last crash as people panicked into the dollar and sent commodities right off a cliff along with equities.  That's why we'll be looking at gold plays as well as hedges to protect gold plays in this article but the key is to control your allocations sensibly - there is no substitute for that.  

Now, let's discuss miners.  Why was my preferred trade idea for the weekend ABX and not gold itself?  Because ABX is a BUSINESS that makes a PROFIT.  As I said in the Newsletter (and last chance to subscribe before the rates double as we move out of Beta):

ABX is an obvious play as you are effectively buying gold but it's gold with cash flow, not just some metal laying in a vault. Their forward p/e is just 13.65 and if gold goes up, that goes down and ABX is sitting on 140M ounces of gold, which is $196Bn at today's price so it's not even worth mentioning their 6Bn pounds of copper ($24Bn) or $1Bn ounces of silver ($26Bn) and you get all that for a market cap of $49Bn vs, for example, owning GLD, which is valued at $48Bn and sort of kind of has contracts that should give them $48Bn worth of gold but they roll them every day and cost investors a fortune in fees and costs while ABX discovers more gold and gets more efficient at mining it and selling it PLUS, they are smart enough to hedge the downturns for you!

Our entry target was $49.66 and ABX opened at $49 on Monday and kindly gave us all morning to get in before taking off in the afternoon and it's already at $51 and climbing as World Bank's Zoellick makes the ridiculous statement that we should go back to backing currencies in gold.  Why is that ridiculous?  Because there is only so much gold in the world and that gold would have to be about $50,000 an ounce to back all the funny money that's floating around these days.  Right now you are thinking of how many ounces of gold you have laying around the house and that is EXACTLY why it will never happen - it would be a random redistribution of wealth and mining companies like ABX would become wealthier than any G20 nation - not going to happen...

Still, that doesn't stop the mathematically challenged crowd from jumping into the gold trade chasing this kind of idiocy and who are we not to take advantage of the stupidity of others?  Our weekend trade idea was to sell the ABX Apr $45 puts for $2.30 and those are still $2 so you didn't miss too much there and who doesn't want to own ABX at net $43 after I said such nice things about them?  Unfortunately, the 2013 $50/65 bull call spread has already jumped to $4.80 but it's still a nice play to buy about 1/2 as many of the spreads as you sell puts.  For example, if you sell 5 Apr $45 puts for $2, that puts $1,000 in your pocket and you can buy 3 of the 2013 $50/65 bull call spreads for $1,440 for a net $440 entry on the 3 spreads.  

To the downside, your worst case is ABX goes down and you are assigned 500 shares in April at $45 ($22,500) plus the net $440 ($22,940) and you own 500 shares of ABX for $45.88 per share, which is 10% below the current price and about ABX's normal mid-range.  If you don't REALLY WANT to own ABX long-term at $45.88 then you don't enter this type of trade at all!  On the plus side, ABX is currently $51 so the trade is $1 in the money and, if gold takes off and ABX gets to $65 in Jan 2013, you have 3 contracts for 100 options at $15 each or $4,500 profit on your $440 outlay (up 923%).  Making 923% in 26 months should help keep you ahead of even Ben's fondest inflationary dreams (we hope!).  

Keep in mind that once we move past April of 2011, if ABX is over $45, your risk of assignment goes away and you entire capital at risk drops to that $440 vs the upside potential of $4,500 so the premise of this hedge is that Gold will stay over about $1,200 through April and, after that, you get to relax with a very nice upside hedge tucked away.  

Since gold has to drop 14% to hurt you - it's a good time to look at a downside hedge to keep us out of trouble.  (GLL) is the ultra-short ETF on gold and it's currently at $28.69.  A 14% drop in gold should send GLL up about 28% to $36.72 so we can sell a single Apr $25 put for $2 ($200) and use that money to offset 2 of the Apr $30/35 bull call spreads at $1.30 ($260) which nets $1,000 (2 x $500) by the time you are forced to buy ABX in April. That buys you another 5% downside cushion should you be assigned and you can up that to 10%, of course (gold $1,050) by doubling it but then you risk being assigned 200 shares of GLL at net $25.60 ($5,120) which could be a good long-term hedge for your 2013 GLD spread but you don't want to go to crazy protecting a small bet (only $440 would be at risk if you are assigned the GLL as they can't both trigger in April).

See how much fun hedging can be!  Now that we know how to protect ourselves, let's look at a couple of other ways to play gold up:

NAK is a long-time PSW favorite.  We were all over these guys in the crash as they fell below $2 but at $10, I like them again thanks to the wonder of options!  (NAK) is a development-stage miner but their holdings in Alaska are about the best untapped reserve left on earth and there are substantial amounts of copper and molybdenum, which is a rare-earth mineral that is in high demand.  NAK may fetch a very high price on a buy-out at some point so the stock is a fun hold at $9.82, selling 1/2 the May $7.50 calls for $2.90 to drop the net to $8.37 with no limit on the upside on 1/2 but that's a wimpy way to play.  I prefer taking the May $7.50/12.50 bull call spread for net $2.25 and selling the $10 puts for $1.50 for net .75 on the $5 spread that's currently $2.32 (309%) in the money.  The risk is being assigned NAK at net $10.75 so this is a pretty aggressive way to play but the upside is, of course, $4.25 on .75 cash committed (567%).  Again, these are just nice ways to stay ahead of inflation...

A much more relaxing way to test the waters on NAK is to go for the deep-in-the-money May $5/7.50 bull call spread at $1.65 and sell the $7.50 puts for .60 so you have a net $1.05 entry on the $2.50 spread.  Making 138% may not seem as sexy as 567% but your worst case here is you own NAK at net $8.55, which is 13% LOWER than the current price and even at $7.50, which is 23% LOWER than the current price, you make the full 138%.  How many trades do you enter where the stock drops 23% and you make 138%?  This is why we LOVE options!  Because you own the $5 calls, the break-even on this trade is way down at $6.78, which is a 31% drop so, logically, you could risk twice as much on this trade and make 2x 138% (276%) vs the much riskier 567% play.

HMY was one of our September's Dozen, which was one of our Members Only posts where we picked 12 trades on September 3rd that I thought were undervalued.  Obviously, with that great timing, all 12 trades hit their targets and HMY was the fastest return with a quick 133% gain (on the options we played).  I rarely pick a straight call on a stock so that's a good indication of how much I liked HMY at $10.25.  Now the stock is $12.50 and a little harder to love but HMY is a similar premise to ABX as they sit on raw gold and if gold is going up, you want to own companies that own physical gold, not delivery contracts.

Do you wish you owned them at $10.25.  Well, guess what?  Through the wonders of options - you still can!  That's right, using our fabulous buy/write strategy, which is detailed in "How to Buy Stocks for a 15-20% Discount," you can BUY the stock for $12.50 and WRITE (sell) the 2012 $12.50 calls for $2.10 and the 2013 $10 puts for $1.85 and that puts you in the stock for net $8.55 with a nice 46% profit if called away at $12.50 in Jan 2012 and, if the stock is put to at $10 you in 2013, you average cost would be $9.27, which is 26% below the current price and lower than HMY has been since May, when gold was $1,150 - which should be good support.  

Don't you wish you had bought all your stocks at 26% discounts?  Options are fun! That's an example of how you use options to mitigate risk, which few people teach you but which we focus on at PSW. Of course, leveraging risk is fun too and HMY is a good one as we can take the 2 May $13/15 bull call spread for .60 and pay for them by selling the 2012 $10 puts for $1.10 because who doesn't want to own HMY for $10?  That puts you in the very aggressive $2 spread for net 0.05 per contract with a 3,900% upside at $15 and you risk losing just $100 for each $4,000 you try to make along with the possibility of owning HMY for a 20% discount.  Fun, fun, fun!  

Please keep in mind that these are similar trade ideas to ones our Members have had for quite some time and they may be exiting positions while you are entering because we teach people to manage portfolios and TAKE THOSE CRAZY PROFITS OFF THE TABLE!  I don't want to pull a Cramer by stampeding the masses into trades so my hedge fund buddies can dump shares on retail "bagholders" but we are concerned that gold could break higher here and it is a good idea to maintain some hedges against cash (which is the position I currently advocate as we fear the market is topping out here).  $1,380 should be firm support for gold and, if it isn't, those GLL plays should do very well so watch the technicals. 

In the end, it's all about the dollar and this morning the dollar is back below that magical 77 line, down almost 1% from yesterday's afternoon and that will mask a lot of market weakness but more about that in the morning report...