Gold Stocks: The Ultimate Options Strategy

Options are becoming more popular as a hedging tool against the next big turn of the market. The next big turn of the market is, more and more these days, what you have to figure out because these big turns are dragging nearly everything along for the ride either up or down. With options, you can limit the damage if the market turns hard the other way from your plan. But options are expensive and take a big chunk out of your rate of return. And they are priced per implied volatility and are thus priced per the VIX - the higher the VIX, the more expensive options become. We are probably going to have to live with the VIX on the historical high side for awhile, so that makes using options to try to get good returns no matter what the market does a very complicated and difficult thing.

Well, put on your thinking cap and try this on for size. Why not just buy and hold gold stocks? It sounds too simple, but look at what gold stocks have done over a large variety of strong market disturbances - from deflation to inflation, from vicious bear to vicious bull:

With gold either steady (as in the '30s) or rising (as in the '70s and now) gold stocks do well no matter what the market does - up, down, or flat. What complicated options strategy can average much better than that? It's a buy and hold stock strategy where you don't have to make a directional bet on the market, freeing you from a lot of dangerous and usually self defeating week to week trading. The investment jungle rarely offers this good of a deal. You just have to be right on gold being in a bear or bull market.

Since November '07, the start of our latest bear market, gold stocks as measured by the HUI Index are only about even, but that's a big outperformance of the Dow. And if you look at this chart:

click to enlarge

You see that the systemic failure issues of late '08 were enough of an aberration to pull gold stocks below the trend over gold's current bull market. These credit and other problems are still a threat to gold miners as they are to any company. But if we can avoid the end of the world, a bull or bear market may allow gold stocks to be one of the best hedging policies.

Disclosure: Long BVN, EGO, AUY, AU, ABX, GFI, RIC, NGD, NG, HL, SA, NXG, GG, RGLD, DROOY, GSS, ANV, HMY, GOLD, CGR, XRA, NEM, GRS.

Comments

[Marco G.]

I concur with the author, gold stocks leverage the up potential in the gold price, and yet may weather a general market demise.

Another thought is to further leverage from stocks, is that of purchasing stock warrants. The warrants give upside participation, yet are lower capital requirements. An example would be Great Basin Gold warrants expiring on October 15, 2010, with an exercise price of $1.60 and now in the market for about $.40. This is 4 to 1 leverage and they are already in the money! The GBG company has 13 + million ounces of Gold and is coming on line next year with 350K ounces of production in 2010.

2009 Nov 02 08:48 AM

[Doc 224899]

If you look at Bruce Pile's disclosure list, it should tell you Bruce likes gold stocks, and some of his positions are "advanced investor" stocks (NG, NXG, RIC, GRS, NGD, EGO).

Bruce, where were you able to get XRA shares?

2009 Nov 02 09:59 AM

[chap08]

"look at what gold stocks have done over a large variety of strong market disturbances - from deflation to inflation"

Where is your deflation period? I hope you are not referring to Homestake in the 29 to 35 period. The boom in gold stocks in this period was due to an inflationary event, not a deflationary one. It was caused by the devaluation of the dollar from $20.67 to $35 on the gold standard. Suddenly, due to a deliberately inflationary government edict, gold production and reserves were worth about 70% more in dollar terms. This kicked off a gold mining boom that doubled production by the end of the 30s.

None of your examples demonstrate the performance of gold stocks in deflation, or when gold is "steady" (for the reason I give above, you are totally wrong to say that gold was steady in the 30s). The reality is that, if we were to return to a deflationary trend, gold stocks would fall hard. During the deflation scare of 2008, gold fell by 30%. If the Fed starts raising rates and the dollar rallies, gold and gold stocks will fall again.

2009 Nov 02 11:58 AM

[twitee]

"If the Fed starts raising rates and the dollar rallies, gold and gold stocks will fall again".

Fed would not dare to raise the rates for a foreseeable future. There is no benefit in rising dollar for the current state of US economy. Gold has nothing to do with inflation or deflation either.

Gold will only rise when the US Economy is in danger or it is unstable. Gold is perceived as the only world reserve currency against dollar. Investors are using gold as an insurance against instability of world economy, especially US.

2009 Nov 02 03:34 PM

[talld]

Gold has broken from the pack with virtually everything it once traded with except for the dollar. The dollar is inversely related to the market. Therefore, if the market goes down, gold will go down, because if the market goes down, the dollar will be going up.

2009 Nov 02 08:34 PM

[Slvrizgold]

Can't say I disagree with your basket of gold stocks, but I notice that Hecla is your only silver play. This is a mistake. Silver is very likely to outperform gold in the entirety of this bull IMO. I think PAAS is a better selection and I wouldn't be without First Majestic Silver. I also notice that do not have Jaguar, easily the best growth profile out there.
I would toss Barrick and double down on NEM. I would take some profits on ultra high flyer GOLD. I would for SURE have Iamgold in my basket of seniors, a very fine company with great mgmt and good growth/takeover prospects. I like that you have plenty of undervalued South African miners, but I'm not keen on perennial loser DROOY. I would much rather have a proven good operator like Semafo that is also very cheap. I like developerment stage names like Exeter and SA, but leery of Novagold, which burned me. Too bad I didn't load up Nova under $1. I would throw out Detour as a dev. name worthy of research. They look just as likely as Osisko to be the next huge North American mine. How about a junior silver producer like Great Panther which is well off its highs, producing positive cash flows, an anemic market cap, growth potential, and real posibility to make some serious cash when silver goes to $25-30+? Also, I think everyone should buy a smidgen of Ventana Gold, which sure as death and taxes is OBVIOUSLY the biggest discovery since Aurelian, the only other monster discovery this decade, and will certainly be aquired. Ross Beaty (founder and Chairman of PAAS) and Brazil's richest both own 10% positions. The stock will be pressured upward strongly with each move up in gold. Thanks for your time, glad to share my knowledge. I knew NOTHING about gold a few years ago and now I live, eat, sleep and breath it. There are LOTS of new investors yet to come around and this will continue to fuel the bull for several more years at the least. Still LOTS of mainstream generalist asleep at the wheel and stuck in their CNBC world of propaganda and false paradigms.

2009 Nov 02 10:34 PM

[Bruce Pile]

It's true that there was the inflationary event in 1934, during the pre-1968 era of the gold price being set by the government, when Roosevelt jumped the price from $20.67 to $35. This devalued the dollar as we are doing now. The gold standard was a major drag back then. Every major currency left the gold standard at some point during the Great Depression.

But the gold mining stocks did 400%+ climbs before 1934, with gold flat during a period of severe general price deflation. For a nice article on this, google "Gold Stocks in a Depression" by Jeff Clark


On Nov 02 11:58 AM chap08 wrote:

> "look at what gold stocks have done over a large variety of strong
> market disturbances - from deflation to inflation"
>
> Where is your deflation period? I hope you are not referring to Homestake
> in the 29 to 35 period. The boom in gold stocks in this period was
> due to an inflationary event, not a deflationary one. It was caused
> by the devaluation of the dollar from $20.67 to $35 on the gold standard.
> Suddenly, due to a deliberately inflationary government edict, gold
> production and reserves were worth about 70% more in dollar terms.
> This kicked off a gold mining boom that doubled production by the
> end of the 30s.
>
> None of your examples demonstrate the performance of gold stocks
> in deflation, or when gold is "steady" (for the reason I give above,
> you are totally wrong to say that gold was steady in the 30s). The
> reality is that, if we were to return to a deflationary trend, gold
> stocks would fall hard. During the deflation scare of 2008, gold
> fell by 30%. If the Fed starts raising rates and the dollar rallies,
> gold and gold stocks will fall again.

2009 Nov 02 11:14 PM

[chap08]

Bruce, I'd seen Jeff Clark's article before. My impression then is confirmed by re-reading the article now.

The performance of gold stocks is heavily dependent on the price of gold. This acts totally differently in a gold standard deflation than in a fiat deflation. As Jeff Clark says:

"We don’t know exactly what an untethered gold price would have done during the depression, but given its distinction in history as a store of value, it’s likely to retain its purchasing power in a deflationary setting regardless of its nominal price."

In other words, as the dollar gained in purchasing power, gold would have fallen in dollar terms, in line with everything else - so retaining its purchasing power. This is confirmedd by gold's action during the deflationary scare of 2008. It fell by 30% in dollar terms.

If you read Jeff Clark's updated piece, his argument is not that gold would benefit from a fiat deflationary environment per se, but that any deflation means that we must have subsequent inflation and THAT implies gains for gold. As he says:

"the overriding concern is that in a fiat system, any deflation will be met with an inflationary overreaction (as we’re seeing). And the worse the deflation, the more extreme the overreaction will be... It’s for this reason that the editors of BIG GOLD urge you to own physical gold"

I agree with that, but what he leaves unsaid is what would happen to gold during the intervening period when deflation was gaining the upper hand. The answer to that seems clear to me. Gold and gold stocks would fall.

On Nov 02 11:14 PM Bruce Pile wrote:

> It's true that there was the inflationary event in 1934, during the
> pre-1968 era of the gold price being set by the government, when
> Roosevelt jumped the price from $20.67 to $35. This devalued the
> dollar as we are doing now. The gold standard was a major drag back
> then. Every major currency left the gold standard at some point during
> the Great Depression.
>
> But the gold mining stocks did 400%+ climbs before 1934, with gold
> flat during a period of severe general price deflation. For a nice
> article on this, google "Gold Stocks in a Depression" by Jeff Clark
>

2009 Nov 03 06:56 AM

[StockMasterFlash]

Gold went down with the market during the crash last time which is generally not supposed to happen, but the crash in march was an unorderly liquidation of all asset classes. I think the lack of faith in the dollar will continue this gold bull market to the upside. Maybe gold is supposed to be higher, but didn't get there because of it's liquidation during the crash.

2009 Nov 03 10:26 AM