Beating the Heat in the Gold Miners Market

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Includes: GDX, GDXJ
by: Hard Assets Investor

By Brad Zigler

Just this week, the GDX/GDXJ ratio—a barometer of investor aggressiveness—reached a new low at 1.66. For those unfamiliar with the ratio, GDX is the Market Vectors Gold Miners ETF, a fund comprising established gold producers, while GDXJ is the Market Vectors Junior Gold Miners ETF, a larger portfolio heavily weighted in junior exploration and development companies.

GDXJ has been on a tear recently, climbing 14% over the past month. GDX has also risen, but not nearly at the junior portfolio's pace. Therefore, the junior portfolio's relative strength is causing the funds' price ratio to decline (see "Good News: A Declining Gold Indicator").

So there's the good news. Junior gold miners are hot. Perhaps a little too hot, in fact. Because the bad news is this: GDXJ's share market now looks overbought.

That's something of a landmark, since this is the first time in the fund's life—GDXJ was launched in November 2009—that it's gotten so far ahead of itself.

A collapse in GDXJ's price isn't necessarily imminent, but the risk of a pullback has increased substantially over the past two trading sessions. That in itself is a good news/bad news scenario.

It's good news for those who've been waiting for a chance to buy GDXJ. But it also leaves them wondering whether or not they should wait for a sell-off. What if the awaited dip never materializes? Or worse, what if it comes ‘round but is missed? If you're a potential buyer, how do make sure you'll be able to get your hands on the ETF shares for an anticipated rebound? And how do you get them a decent price?

Well, one way is to do a little calendar spreading with GDXJ calls. Calls, of course, grant their owners the right to buy the underlying asset at a stated price anytime before the option expires. A calendar spread entails purchasing a call of long duration against the sale of another call with an earlier expiration. The premium collected from the call sale helps to lower the cost basis of the purchased option.

Calendar Spread

Let's look at an example. With GDXJ trading at $32.52 on Wednesday, a November $34 call could have been purchased for $1.20 per share. At the same time, an October $34 call was bid at 75 cents. Spreading these two calls results in a net debit, or out-of-pocket option premium, of 55 cents a share. So that's $55 per spread.

Why spread these two calls? It's a precision trade—but not an unforgiving one—that allows you to capitalize upon any near-term weakness in GDXJ's price to acquire shares cheaply. If GDXJ declines during the life of the October call, that option could expire worthless, leaving you owning the November contract at a lower cost than if you bought it outright. Ultimately, you can then exercise your call to obtain your ETF shares.

Maximum Risk

The risk in this trade is maximized if GDXJ declines enough to make both options worthless, or, alternatively, if GDXJ rises enough to develop intrinsic values in both contracts. In either case, the options would trade or be valued at parity. This risk is limited, though, to the net premium paid—55 cents—to initiate the position.

Maximum Profit

At the expiration of the October call, the position's maximum profit would be realized if GDXJ trades at the $34 strike price. If GDXJ is above this level, the expiring option would still have some intrinsic value; if GDXJ was lower, then the November option wouldn't be worth as much. Once the October call expires, you're left with a long call position that has an unlimited profit potential on an up move.

Breakeven

If the October call goes off the board, the long November call's expiration breakeven would be $34.55—equal to the option's strike price plus the net premium paid. During the life of the October call, however, the spread could actually break even at a different price level owing to the options' implied volatilities and how their time decay rates fluctuate.

Volatility

An increase in the options' implied volatilities would positively affect the spread. Volatility increases most dramatically in a downdraft with longer-term options having greater sensitivity.

Bottom Line

A calendar call spread can be an ideal way to acquire shares when a near-term decline in share prices is anticipated. Simply put, it affords investors a way to turn overheated call premiums into a cool tool.

Disclosure: None