Options as a 'Gold'en Opportunity

by: Hard Assets Investor August 18, 2008 | about stocks: GDX / GLD    
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By Brad Zigler

Gold has certainly been thwacked in the past few weeks. As much as gold has fallen, though, gold stocks have plunged even farther. We've chronicled some of the woes besetting miners in a number of articles, including a recent feature entitled "What's Wrong With Gold Stocks?".

The sell-off in mining stocks has been so deep that they look, at least to some, historically cheap in relationship to gold itself. Larry McMillan, in fact, thinks miners are good buys now. Or, rather, McMillan thinks options on miners are good buys.

You may remember us tracking McMillan's winter heating oil/gasoline spread in our feature "Oil-Slicked Road To Spread Profits." McMillan is the author of the option trader's bible, "Options As A Strategic Investment," now in its third printing.

The most direct way to play a bullish hunch with options, McMillan will tell you, is to purchase call options. And that, in fact, is what he recommends to his newsletter subscribers now.

Call options give their owners the right, but not the obligation, to purchase the contract's underlying shares at a specific price no matter their actual market value. Following McMillan's suggested purchase of the December $32 Market Vectors Gold Miners ETF (GDX) call, for example, traders would be entitled to buy 100 shares of the fund at the $32 strike anytime before the option expires in the third week of December. When McMillan made his recommendation last week, GDX was trading near $36 per share, so this option's $6.50-per-share cost reflected nearly $4 of "in-the-money" premium.

McMillan, however, isn't recommending a naked call purchase. He instead hopes to leverage the appreciation of gold mining shares against gold bullion by purchasing in-the-money puts on the SPDR Gold Trust Shares (GLD) as well. McMillan recommended the purchase of $86 December puts when GLD was trading around $80 per share. A put offers its owner the right to sell, rather than buy, the contract's underlying shares at the exercise price.

McMillan argues that a put/call spread is superior to an ETF spread because the option trade can crank out profits if the price spread between the two underlying ETFs converge, or if market volatility increases, causing both options to change substantially in price.

"Suppose both sides of the relationship rise sharply in price," says McMillan. "We own a put on one and a call on the other. The call would profit handsomely, while the put can only lose a fixed amount of money. So, this second way of making money works even if the two entities don't converge in price."

The relationship between gold mining shares, proxied by GDX and gold, represented by the GLD trust, languished until a year ago. The ratio of GLD's price to GDX then started to climb, breaking above 2 last month, as mining stocks plunged. "The selling in gold stocks," says McMillan, "has been torrential recently."

Gold (GLD)/Gold Stock (GDX) Ratio

Chart: Gold (<a href='http://seekingalpha.com/symbol/gld' title='More opinion and analysis of GLD'>GLD</a>)/Gold Stock (<a href='http://seekingalpha.com/symbol/gdx' title='More opinion and analysis of GDX'>GDX</a>) Ratio)

 

Last week, however, the ratio gave signs of peaking, so McMillan hopped aboard the ratio train for a ride southward.

To effectively capture changes in the GLD/GDX relationship, though, you have to determine the ratio of puts to calls in McMillan's spread recommendation. That's determined by the formula:

Ratio = (p1v1d1) ÷ ( p2v2d2)

Where:

pi = underlying stock's price

vi = underlying stock's volatility

di = option delta

i = option

1 = put

2 = call

 

Volatilities, which McMillan supplies on his Web page, represent the underlying shares' price variance over a specific period of time. GDX's volatility has been clocked at 42% over the past 100 trading days. For GLD, volatility is more modest: 24%. Thus, before adjusting for delta risk, the put/call ratio, with GLD now at 77.63 and GDX at 34.46, is (77.63 x 0 24) ÷ (34.46 x 0.42), or 1.29. This implies that you'd buy 13 GLD puts for every 10 GDX calls purchased.

The Greek term delta describes the expected rate of change in an option's value for a given shift in the price of its underlying shares. The premium of an option with a .50 (50%) delta, for example, can be expected to move 50 cents for every dollar change in the price of the stock. Deltas can be derived by using an options calculator such as that supplied online by the Options Industry Council.

When McMillan cooked up his spread notion, the deltas of the December GDX $32 calls and the December GLD $86 puts were closer together than now. The puts' delta is currently 50%, while the calls track their underlying shares at a 66% pace. Adjusting for the delta differential (0.50 ÷ 0.66), we get a put/call ratio of 0.98, or pretty much one-to-one.

Market volatility over the past week has already had an effect on McMillan's spread. When he put out his recommendation, a one-to-one combo could have been bought for $15.60 per share ($1,560 per spread):

With GDX @ $35.87: Buy GDXLF (Dec. 32 call) @ $6.50

With GLD @ $79.50: Buy GLDXH (Dec. 86 put) @ $9.10

 

At last look Friday, though, the call was offered at $5.50, the put at $10.60. McMillan's put a limit on this trade at $16 per share, so it looks like a gold rally is needed to help latecomers get their spreads on.

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This article has 10 comments:

  •  
    Aug 18 03:47 PM
    It does not make sense even if one really tries to understand. Gold and GDX are going a lot higher from here own, they both have been way oversold and only move from here is up. And GLD puts are not cheap either. So why erase a big chunk of your GDX profits by betting against GLD which is surely moving higher from this point. Also I doubt if GDX will go up with GLD going down !
    Reply | Link to Comment
  •  
    Aug 18 04:36 PM
    I agree, this "strategy" is just plain silly.
    Reply | Link to Comment
  •  
    Aug 18 08:50 PM
    I agree I'd go long with the GLD and short the GDX before the converse... it's a "real" asset vs. a paper equity ultimately.
    Reply | Link to Comment
  •  
    Aug 19 02:50 AM
    Hello say you fellows sound knowledgeable.
    Can anyone advise a viable really safe way to wharehouse bullion coins and be ready to sell if by chance the fiat money printed finally starts a forrest fire with inflation? help
    Reply | Link to Comment
  •  
    Aug 19 08:59 AM
    jigs -

    On the contrary, GLD puts ARE (were) cheap. The implied volatility embedded in the GLD premium was only in the 77th percentile while the the GDX calls' volatility was in the 96th percentile.

    Reply | Link to Comment
  •  
    Aug 19 10:59 AM
    It is the strangest market I have seen in a long time. On the one hand inflation is skyrocketing, and hard assets are falling on the other. Either this means really bad times ahead, or commodity prices must recover.
    Reply | Link to Comment
  •  
    Aug 19 11:50 AM
    The complaints are so much noise. The complainers simply don't understand the suggested trade. Look at this chart from StockCharts:
    stockcharts.com/h-sc/u...=$GOLD:$XAU&p=D&am...

    The miners $XAU are about as cheap as they ever have been related to the price of gold. A few days ago they were cheaper - now still pretty cheap.

    The trade is not a Gold direction trade - although a gold price pop would probably help the trade as it would probably pop the miners even more than the Gold.. It is a convergence trade on the narrowing of the relationship in prices. Using the several months out and the ITM contracts should help with little time value decay.
    Reply | Link to Comment
  •  
    Aug 19 05:31 PM
    Seeing as this is a take on McMillan, we should refer to his explanations for doing this trade. Its hedged. You should expect to make less profit on a hedged position than on a speculative position.

    Why make a hedged trade? I would say in this market, it makes a lot of sense. It is so easy to miss a directional move.
    Reply | Link to Comment
  •  
    Aug 19 08:41 PM
    Interesting conversation- where the out of the ground cost of mining an ounce of gold is now $600, there is effectively a floor under us. I'd see $1200 as reasonable in the next 2-3 years. As such, the relative risk reward is compelling for a reasonable portion of a portfolio.
    Reply | Link to Comment
  •  
    Aug 20 11:25 PM
    Brad, I see total upside of 50% on this trade with a maximum downside of 33% (the time premium on the put and call option). There is virtually no leverage to higher gold prices unless gold stocks significantly outperform. The 50% gain would come around a gold price of $600 by end of December (how likely is that). I'd grade this trade a B-. For 1/3rd the cost (the amount at risk), you can strangle Dec. GLD with an 87 call and a 75 put. At $600 gold, that's a 200% profit and you have unlimited upside. What am I missing?
    Reply | Link to Comment
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