Riding the Gold Roller Coaster: Scary, Thrilling but Not Risky

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Includes: AUY, PAAS
by: Davy Bui

Last week, I closed my Yamana Gold (NYSE:AUY) April 2011 $13 covered call position at $0.22 per contract with the stock trading at $12.80, near its strike price. By week's end, AUY traded up to $13.30, justifying the trade for the time being. I initially opened this position at $0.47 late last year so a realized premium of 1.7% was collected against my AUY holdings. Buying back the call options allows me to retain my AUY position and continue to take advantage of something frequently advertised as the one of the gold sector's main risk -- massive volatility.

Volatility is a familiar term due to the rising popularity of options trading and the market's crash in 2008/2009, which spiked the VIX index to previously unimaginable heights. When discussing the gold/precious metals sector, investors are often encouraged to bring "a strong stomach" to withstand the ups and downs of gold's roller-coaster ride. In this case, a roller-coaster may be a perfect analogy. Most folks visiting an amusement park gladly get on roller-coasters, expecting spills, thrills and ultimately, a safe exit. In the world of investing, nothing is ever guaranteed but uncertain times and easy monetary policy suggest the gold roller-coaster may still be a safe ride.

Instead of fearing the sickening volatility of the gold sector, investors can use options to harness these price swings to their benefit. Options trading can get quite exotic, with a whole bevy of Greek letters and formulas awaiting, but a few basic principles and a conservative strategy has served me well.

Because the price of a given option contract is highly dependent on the underlying stock's historical volatility (more volatile stocks generally have more expensive options), the gold sector's wild movements make it ideal for options trading. By writing covered calls against my gold positions, I collect higher premiums than I would for stocks such as Microsoft (NASDAQ:MSFT) or Johnson & Johnson (NYSE:JNJ). Because these gold positions are as likely to drop drastically as move up, I often get the chance to close my position at an acceptable profit early on and wait for the next opportunity (when the stock moves up again) to write more covered calls. In any case, this volatility is priced into the option so even if the stock hardly moves, the option's time decay (a loss of value as the option nears expiration) allows me to close the position at a later date for a profitable transaction.

My stake in Yamana Gold (AUY) is a good example. Last week, with only a few days left until expiration and AUY hovering near the strike price (trading around $12.90), it made sense to buy back the position for a small realized gain to preclude being exercised out of the stock. Though $13 is a satisfactory price, keeping the stock allows me to continue writing covered calls.

Even if I was OK with $13 for AUY, I might want to close the covered call position. By buying back the call at $0.22, I could have sold a July 2011 $13 covered call option for $0.83 last week, realizing an additional $0.61 or 5% gain on a sale of AUY at $13 for the small cost of deferring the transaction 100 days.

I initiated my AUY position in January 2009. In addition to the 80% gain in the share price, I have been writing covered calls against my shares along the way, collecting an additional 19% gain via option premiums in little over two years.

This volatility also gives investors a chance wait out any price moves against them. For example, I opened a covered call position in Minefinders (MFN) at a strike price of $13 expiring August 2011. At the time, the stock was trading near $12 but has since moved up to $15.48. I initially collected a premium of $0.80 but this contract last traded at $2.70 for a true cost of $1.90 to buy back the contract if I want to retain my MFN stake. However, four months is a long time in the gold sector and the stock will likely give me an opportunity to buy back the option at a better price.

Are there risks to pursuing this strategy? Yes but in some ways, these are "safe" risks. Options are usually taxed as short-term capital gains. Because I hold the stock, I am always taking the chance the stock could drop dramatically but this risk exists regardless of whether I write covered calls. In fact, covered-call writing mitigates this risk somewhat by reducing total possible loss by the amount of the call premium. As with the Minefinders position, I do take the real risk of losing out on a move up in the stock, since I am committed to selling a currently $15.50 stock for $13. Will MFN still be $15.50 come August? Even so, no actual loss of capital is involved -- is a risk that still makes money even if I lose out really that risky?

Of course, those are just risks associated with a covered call option strategy. There are different risks pertaining to the gold sector and the specific mining companies mentioned, which this article does not address. As mentioned briefly, record-low interest rates and global instability suggest gold's bull run is likely to continue, though I am not inclined to open a new position at these prices. As for Yamana and Minefinders, a discussion of those companies' inherent worth is a topic for another post. Trading in gold stocks and options definitely is not suited for everyone and readers should seek professional advice for their specific situation.

Roller-coaster rides are scary, not risky -- people get on them for manufactured thrills but expect to get off safe and sound at the end. So it is with the gold sector. Prices may oscillate wildly but with the current economic climate, I expect to profit by riding it out.

Disclosure: I am long AUY, MFN. Also short short MFN calls.