By Brad Zigler
Gold has certainly been thwacked in the past few weeks. As much as gold has fallen, though, gold stocks have plunged even farther. We've chronicled some of the woes besetting miners in a number of articles, including a recent feature entitled "What's Wrong With Gold Stocks?".
The sell-off in mining stocks has been so deep that they look, at least to some, historically cheap in relationship to gold itself. Larry McMillan, in fact, thinks miners are good buys now. Or, rather, McMillan thinks options on miners are good buys.
You may remember us tracking McMillan's winter heating oil/gasoline spread in our feature "Oil-Slicked Road To Spread Profits." McMillan is the author of the option trader's bible, "Options As A Strategic Investment," now in its third printing.
The most direct way to play a bullish hunch with options, McMillan will tell you, is to purchase call options. And that, in fact, is what he recommends to his newsletter subscribers now.
Call options give their owners the right, but not the obligation, to purchase the contract's underlying shares at a specific price no matter their actual market value. Following McMillan's suggested purchase of the December $32 Market Vectors Gold Miners ETF (NYSEARCA:GDX) call, for example, traders would be entitled to buy 100 shares of the fund at the $32 strike anytime before the option expires in the third week of December. When McMillan made his recommendation last week, GDX was trading near $36 per share, so this option's $6.50-per-share cost reflected nearly $4 of "in-the-money" premium.
McMillan, however, isn't recommending a naked call purchase. He instead hopes to leverage the appreciation of gold mining shares against gold bullion by purchasing in-the-money puts on the SPDR Gold Trust Shares (NYSEARCA:GLD) as well. McMillan recommended the purchase of $86 December puts when GLD was trading around $80 per share. A put offers its owner the right to sell, rather than buy, the contract's underlying shares at the exercise price.
McMillan argues that a put/call spread is superior to an ETF spread because the option trade can crank out profits if the price spread between the two underlying ETFs converge, or if market volatility increases, causing both options to change substantially in price.
"Suppose both sides of the relationship rise sharply in price," says McMillan. "We own a put on one and a call on the other. The call would profit handsomely, while the put can only lose a fixed amount of money. So, this second way of making money works even if the two entities don't converge in price."
The relationship between gold mining shares, proxied by GDX and gold, represented by the GLD trust, languished until a year ago. The ratio of GLD's price to GDX then started to climb, breaking above 2 last month, as mining stocks plunged. "The selling in gold stocks," says McMillan, "has been torrential recently."
Last week, however, the ratio gave signs of peaking, so McMillan hopped aboard the ratio train for a ride southward.
To effectively capture changes in the GLD/GDX relationship, though, you have to determine the ratio of puts to calls in McMillan's spread recommendation. That's determined by the formula:
Ratio = (p1v1d1) ÷ ( p2v2d2)
pi = underlying stock's price
vi = underlying stock's volatility
di = option delta
i = option
1 = put
2 = call
Volatilities, which McMillan supplies on his Web page, represent the underlying shares' price variance over a specific period of time. GDX's volatility has been clocked at 42% over the past 100 trading days. For GLD, volatility is more modest: 24%. Thus, before adjusting for delta risk, the put/call ratio, with GLD now at 77.63 and GDX at 34.46, is (77.63 x 0 24) ÷ (34.46 x 0.42), or 1.29. This implies that you'd buy 13 GLD puts for every 10 GDX calls purchased.
The Greek term delta describes the expected rate of change in an option's value for a given shift in the price of its underlying shares. The premium of an option with a .50 (50%) delta, for example, can be expected to move 50 cents for every dollar change in the price of the stock. Deltas can be derived by using an options calculator such as that supplied online by the Options Industry Council.
When McMillan cooked up his spread notion, the deltas of the December GDX $32 calls and the December GLD $86 puts were closer together than now. The puts' delta is currently 50%, while the calls track their underlying shares at a 66% pace. Adjusting for the delta differential (0.50 ÷ 0.66), we get a put/call ratio of 0.98, or pretty much one-to-one.
Market volatility over the past week has already had an effect on McMillan's spread. When he put out his recommendation, a one-to-one combo could have been bought for $15.60 per share ($1,560 per spread):
With GDX @ $35.87: Buy GDXLF (Dec. 32 call) @ $6.50
With GLD @ $79.50: Buy GLDXH (Dec. 86 put) @ $9.10
At last look Friday, though, the call was offered at $5.50, the put at $10.60. McMillan's put a limit on this trade at $16 per share, so it looks like a gold rally is needed to help latecomers get their spreads on.