Brad Zigler: Bailing Out Of Gold Miners

March 03, 2011

Owners of gold stocks hoping to resurface from an underwater position need look no further than the options market.

 

Earlier this week, we pondered the implications of company officers buying a certain junior mining stock ("Insiders Buy A Gold Junior. Should You?").

The article featured a chart showing the relative performance of mining stocks—collectively represented by the Market Vectors Gold Miners ETF (NYSE Arca: GDX) and the Market Vectors Junior Gold Miners ETF (NYSE Arca: GDXJ)—to gold itself.

 

Gold Miners' Relative Strength Vs. Gold

Gold Miners' Relative Strength Vs. Gold

 

As the chart indicates, juniors are slumping, but established producers have been positively—or, more accurately, negatively—languid compared with bullion. Just ask an owner of Kinross Gold Corp. (NYSE: KGC) or Newmont Mining Corp. (NYSE: NEM), which are both top-10 holdings of the GDX portfolio. Kinross is down 17.7 percent this year alone, while Newmont's off 10.9 percent.

Long-term owners of these stocks have piggybacked on bullion's good fortunes, but more recent acquirers have been disappointed with the issues' recent performance. For many, an allocation to the miners may now seem like a poor choice. Some may hope to just break even on their investment and look for better prospects elsewhere.

Gold's current buoyancy sparks new hope for a break-even move in the producers. After all, Kinross' and Newmont's stock prices are fairly well correlated to bullion—at 64 percent and 67 percent, respectively.

Stockholders looking to bail from an underwater position without a loss must either hope the stocks rally to their purchase price or attempt to lower their break-even points by "averaging down"; that is, by buying additional shares at the now-lower market price.

Adding shares to a losing position, however, exposes the investor to more, not less, risk, as capital must be funneled from other allocations.

Luckily, the option market offers a strategy that allows an investor to lower his/her break-even point without adding any money. It's called a call ratio spread.

"Whoa!" I hear you say. "Ratio spreads? Options? Way too complicated!"

It's really not. Give me a minute to explain.

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