Investing In Gold With Protection

Includes: GOLD
by: PowerOptions

Occasionally I get asked the question, “should I invest in gold now?” I usually get this question when the price of gold is already in the stratosphere, as is the current situation for gold. My reply to the prospective gold investor is that I don’t consider gold in and of itself as an investment. My definition of an investment is a value creating entity generating a profit. Gold is of value, but it doesn’t create value. Gold may be used to make jewelry, hedge an investment or even hedge a currency, like the U.S. dollar, but gold by itself does not create value. There is some speculation the large amount of debt issued by the U.S government could cause significant devaluation of the U.S. dollar and in that situation an investor holding gold would be in good shape and look all the wiser, as the price of gold would appreciate against a falling dollar.

I explain to investors seeking to invest in gold, that gold mining companies are a way to invest in gold. Gold mining companies are an investment, as they create value and profits from finding, mining and processing gold. As the price of gold increases, the amount of profit gold mining companies realize increases and in addition the company’s respective stock price also appreciates.

A problem with purchasing gold or investing in gold mining companies is the price of gold tends to revert to the mean. A chart for the price of gold adjusted for inflation is shown below:

(Click charts to expand)

As can be seen, the price of gold peaked at $2652.39/oz on January 21, 1980, when adjusted for inflation and then progressively declined until the first of 2001. Since 2001, the price of gold has progressively increased and is currently around $1741/oz. Historically, the price of gold has a habit of spiking and then falling back to the mean. The price of gold currently has a long way to go to reach its previous peak achieved in January of 1980, but it also has a long way to drop before it reaches the valley. The average price for gold is around $700 over the time period presented in the graph, so the price of gold is well above the mean at this point.

Unfortunately, the reverse is also true for gold mining companies, as the price of gold drops, the amount of profit realized by gold mining companies is reduced and the gold mining company’s stock subsequently drops in price.

Purchasers of gold and/or investors in gold mining companies able to time the peaks and valleys for the price of gold can make a considerable profit. However, timing the peaks and valleys is tenuous at best, as there are a lot of variables involved in the price of gold such as supply, demand, sovereign currency manipulation, sovereign debt, global economy, etc. As illustrated in the graph above, the price of gold for the previous spike dropped almost as quickly as it rose and was also very volatile near the peak, so an investor making a play with gold has to be very nimble in timing trades.

The previous spike in gold price took around nine years to go from trough to peak and the current appreciation in gold price has been progressing for around nine years, so historically, the price of gold appears to be a little “long in the tooth.”

Even after the previous discourse relating the difficulties of investing or making a play with gold, I’m sure there are still some investors seeking to get into gold, but what to do?

A gold mining company to consider is Rangold Resources (NASDAQ:GOLD), which was recently tagged as having the highest projected earnings growth for companies in the gold industry.

Rangold Resources has significant gold mining operations in Africa. In its most recent earnings report, the company reported record profit, production and sale of gold.The company increased its sale of gold by 72% year-to-year.

With regard to some of the company’s operations in Cote d’Ivoire (Ivory Coast), Rangold indicated it is observing a lot of positives with respect to the new Cote d’Ivoire government related to privatization, capitalization and permits. The new government was “installed” following November 2010 elections after a brief civil war and refusal of the incumbent to step down. The new government of Cote d’Ivoire plans to significantly develop mining operations in the country and improve the electric power infrastructure for powering mining operations.

Rangold considers one of its proficiencies as exploration and if conditions are favorable, Rangold Resources plans to expand its operations to Russia in the next 5 to 10 years.

A graph of Rangold’s stock price is shown below:

As can be seen, the price of Rangold’s stock has increased significantly over the previous year, experiencing a return of around 50%. Additionally, Rangold’s P/E ratio of 49 is at a premium. A little bad news related to the company or its industry could see Rangold’s stock price drop quickly back to its previous support level of around $90 or even to its $75 support level.

An investor seeking to enter a position for Rangold Resources might consider a collar position for the company. A collar is entered by selling a call option against a purchased or existing stock with some of the proceeds from selling the call option used to purchase protection via a put option.

For example, using PowerOptions search capabilities, a collar position was found for Rangold Resources with a potential return of 2.6% and a maximum potential loss of 6.7%. The time frame for realizing the potential return is 18 days. The call option to sell for entering the collar is the 2011 November 110 with a price of 4.60 and the put option to purchase is the 2011 November 100 at $1.30. A profit/loss graph for the collar position is shown below:

With Rangold Resources releasing its earnings on Wed November 2, 2011, an investor entering the collar position might sleep well knowing it is not possible to experience a loss of greater than 6.7%, even if the price of Rangold's stock drops to zero.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.