You’ve no doubt read several doom and gloom articles already here in 2019. Likely, you’ve also already read a few contrarian bullish outlooks for the new year as well. There’s something missing from all of this conversation, however… actual analysis.
You see, when markets become volatile, like we’ve seen over the last month or so, financial journalists and sensationalists come out of the woodwork and begin prognosticating about its future, as if the entire market always moves all in one direction at all times.
The truth is, there are going to be certain sectors that perform well and others that just don’t. That’s how it’s always worked. This recent market slump has once again taken the much-needed detailed analysis out of the market forecasts. That’s a shame, since this is the time of year we get the most of them.
Fortunately, when markets become so separated from reality, it does leave unique opportunities in its wake. One of these opportunities is in a sector that should be doing extremely well right now: mining stocks.
Historically, anything gold or silver related is the it thing when markets slump. The idea is straightforward: investors fear stocks sliding, so they fall back to safe places like Treasuries and gold.
To some extent that’s been sort of happening in Treasuries, but in a worrying fashion. Despite the rising interest rates forced on the market by the Fed, investors have been narrowing the Treasury yield curve:
This means that investors are buying longer-term protection from market woes in the form of 10, 20 and 30-year Treasuries. Many fear this flattening of yields or the potential even for a full inversion will be the frontrunner to an actual recession. But that’s a topic for another day.
For mining stocks, the story is a bit different. Sure, they haven’t performed terribly compared to the rest of the market. But instead of not so bad, they should be rising considerably if investors are indeed so scared of today’s investment environment.
As you can see, the Vaneck Vectors Gold Mining ETF (GDX) (in black) has recovered all of its losses compared to the S&P 500 (ironically in gold) during the second half of 2018. But it could be easily argued that this performance has been late and not yet finished.
A lot could still happen in this new year. President Trump could come out as a true dealmaker, cutting deals with the Democrats in the House, China on tariffs and the Fed to halt further rate hikes. But the opposite is just as likely… that 2019 will be just as messy for all involved.
If that’s the case, and chaos continues to surround the investment community, gold stocks are the place to be… at least in the short term.
As we noted, they haven’t been getting the headlines they deserve. Investors should be flocking to them in this volatile period. But as the above chart shows… that may be just starting.
A Strategy For Short Term Bulls
The real question you should be asking yourself if you believe precious metals prices will rise is how to invest.
You could simply pick up shares of a few mining stocks. But individual miners come with some serious risks. A vein could dry up, regulators could shutter a mine or a foreign government could nationalize its whole operations somewhere.
Alternatively, you could buy shares of an ETF like GDX. But as we’ve often discussed, that means a longer-term commitment and more money to get started than many of us prefer.
So, once again, we fall back on one of our favorite strategies for securities we believe will rise in the short term: a bull call spread.
A trader enters a bull call spread by buying a call option on a stock or ETF he believes will rise with a strike price near its current trading price. He then sells a call option with a higher strike price but the same expiration date.
The money he collects from the call he sold offsets the amount of money spent to enter the call option he bought. It limits the upside profit potential, sure. But it also limits the amount of capital at risk and the amount to enter the trade, which are the same.
The initial outlay is the total risk in each bull call spread. The maximum profit potential is found by take the difference in strike prices and subtracting this cost.
Here’s a good graph to give you an idea of how this plays out:
Source: The Options Industry Council
Let’s take a look at a specific example of a bull call spread on this gold play…
A Specific Trade For GDX
As noted above, GDX gives us a good basket of gold miners to look at. It has all the majors and quite a few smaller ones, as well. As more investors fall back to the safety and security of the yellow stuff in uncertain times, GDX is definitely one place that’ll do well.
It is trading just over $21 per share. So, that’s the best place to start.
A trader looking to use a bull call spread on GDX could buy a January 18 $21 call for $0.79 per share and sell a January 18 $22 call for $0.30 per share. This results in a cost of $0.49 per share. Since each contract represents 100 shares, that’s $49 for this trade.
That’s the most at risk here… $49.
The maximum profit this trader could make if shares do rise above $22, which isn’t too hard of a stretch, is found by that formula above. Take the difference in strike prices ($22 – $21 = $1) and subtract the entry cost ($1 – $0.49 = $0.51). So, per contract, that’s a maximum profit potential of $51.
That works out to a return of 104.1% on the total amount of risk during the three weeks of this trade. With investors just now starting to come over to the safety of gold — at least until we get answers on the government shutdown, the trade war with China and so much else — that’s a nice potential return on a set and known limited risk.
— The Option Specialist