Gold has been in a rut for years now. It simply isn’t moving higher or lower. This is a relatively new state of things. Take a look at the past two decades of gold prices:
The yellow metal rallied almost incessantly until peaking at 1900 per ounce in 2011. After investors took their profits, prices have stabilized to the point of boring. With prices stuck in a tight range of 1,100 to 1,400 for the last five years, it’s made it difficult for gold miners to breakout in either direction.
Take Barrick Gold Corp. (NYSE:ABX):
Besides one giant spike in 2016, this industry leader has slipped sideways and slightly down over this long period. Compare that to the rest of the market:
As you can see, it hasn’t been a very fruitful endeavor to invest in Barrick in a long while. That could soon be changing.
A Deal to Break the Mold
Barrick just cut a deal with another major player in the gold mining industry: Randgold Resources Limited (NASDAQ:GOLD).
In an all-stock deal, Randgold has agreed to be acquired by Barrick in the first quarter of next year. This week, both companies’ shareholders approved the deal. And many are hailing it as a tremendous move for both.
The new company will own more gold reserves than any other company on the planet, have the largest earnings from operations of any gold miner and carry the lowest cash costs in the industry.
Both companies are so confident that this deal will result in immediate growth, each have decided to offer larger-then-previously-announced dividends in the fourth quarter.
Are there downsides? Sure, the new company will have plenty of geopolitical issues to deal with, including potential nationalization of its African properties and continued disputes with the Chilean government over its Pascua-Lama project.
But none of this is new. These companies have been dealing with these issues well before they decided to combine. These dangers are certainly priced into their stocks and have been for years. Still, even with the recent post-deal rallies in each company’s share prices, they still trail gold’s lackluster performance over the last 12 months:
Any sensible person can see that there’s still room to run here. There is a way to take advantage of this ahead of the merger, without risking huge losses. It features a strategy we discuss frequently here. So, let’s take a look at it now.
A Strategy for Short Term Bulls
A bull call spread is a type of trade that seeks to reward short-term bulls with the majority of any short-term stock increases, while limiting their risk.
To enter one, you need to buy one call with a strike price close to the underlying stock’s current price and sell another with a higher strike price.
This results in a net debit to your account. That’s the total risk of the trade, what you put down to get into it.
The reward comes if you are right, and the stock does climb. The maximum you can make occurs when the underlying stock rises above the strike price of the sold call.
The maximum profit you can make with this kind of strategy is the difference in strike prices between the two call options minus the outlay to get into the trade (premium paid minus premium received).
Here’s a graph of how this strategy can play out:
Source: The Options Industry Council
As you can see, the higher share prices go, the more money you stand to make… up to the higher strike price.
With a trade in gold, this kind of strategy works well… especially when there’s a merger in the making.
You see, if any bit of news comes out about extra synergies, new opportunities or simply regulatory approvals before expiration of the call options, you can expect prices in both companies to increase.
We’ve already seen some of this with the recent approval by the South African government (where, the new company will have mines), the surprise Q4 dividend hikes and the stockholder approval votes for the merger. Depending on which expiration date you choose for this strategy, a lot more can happen to positively affect share prices.
But since a deal like this includes many unknowables, the more reserved bull call spread offers protection a regular single call option doesn’t.
A Specific Trade for ABX
To maximize the potential for favorable news to spur a price spike, while limiting your holding time, ABX December 21 call options offer a sweet spot.
As of right now, you could buy December 21 $14 calls for $0.25 and sell December 21 $15 calls for $0.11. This results in a net debit of $0.14 per share. Since each contract is worth 100 shares, your total cost would be just $14.
That’s the total risk. Obviously, you can trade more contracts to increase your exposure and therefore profit. But we’re talking about a trade at minimum costs $14 per contract plus commissions.
The maximum profit on this trade is found by taking the difference between strike prices and subtracting the cost of entering the trade.
For this particular ABX trade, that means the total profit potential is $0.86 per share ($15 – $14 = $1; $1 – $0.14 = $0.86). Since each contract is represents 100 shares, that’s a maximum profit of $86.
Since this trade requires just $14 per contract to enter, that $86 potential profit would be a 614% return on your risk.
To be fair, shares do have to move quite a bit to reach this maximum profit. Currently ABX trades at $13.15 per share. But a move of this size is quite possible as the GOLD deal moves forward. And the risk-reward of the trade is clearly appealing.
— The Option Specialist