Brad Zigler: Bailing Out Of Gold Miners

March 03, 2011

 

Let's say you bought 100 shares of Kinross—now trading at $15.60 per share—at $18.00 earlier this year. You're presently $2.40, or 15.3 percent, away from breaking even and now think your assets could be employed more profitably elsewhere.

 

Kinross Gold Corp. Vs. Gold Bullion

Kinross Gold Corp. Vs. Gold Bullion

 

If we look at the option market, we'd see a KGC May $16 call is now offered at 80 cents a share, while calls with a $17 exercise price can be sold for 40 cents a share.

Calls, of course, convey the right—but not the obligation—to purchase the underlying stock at the strike, or exercise, price. Purchasing the $16 call means you can buy 100 shares of Kinross anytime before the call's May expiration. Selling calls, on the other hand, obligates you to deliver 200 KGC at the $17 strike price, should the buyer choose to exercise his/her right.

You could buy the $16 option and finance its purchase with the simultaneous short sale of two $17 calls. Doing so, you'd overlay a call spread on your stock position with no capital or margin commitment.

But to what end?

Well, let's look at a couple of scenarios.

Suppose KGC advances to $17 in May. Your stock would still be $1 underwater. Your long call, assuming the market's wrung out all of its time value—likely as expiration approaches—would be worth $1 a share. The $18 calls would be out of the money, making them worthless.

You'd lose $1 on the stock, but make a buck on the long call. You're now breaking even at $17, a dollar better than your original basis. Thusly spread, you're only asking KGC to rise $1.40, or 9 percent, to bail you out.

That's an important point. You still need the stock to rise to lift you of your predicament. Just not as much as before.

And you have to be willing to lose the stock should a strong rally develop. Suppose, for example, Kinross climbs to $20. You'd be $2 to the positive on your shares, and your long call would be worth at least $4, but those two short calls would each be $3 in the money. The value of your assets—your long stock and long call—would offset your short call liabilities.

In all likelihood, though, you'd probably be assigned on the short calls. By exercising their contract rights, the call owners would force you to deliver stock. That's not a problem, because neither of the two calls you sold were naked. One is covered by your stock ownership; the other by the $16 call you purchased. At this point, you could deliver your long stock and exercise your long call to obtain another 100 shares.

It's for that reason that no margin is required, though the trade must still be done inside a margin account.

There's still the downside to consider. Losses remain open-ended below the $17 break-even point, so this position doesn't provide hedge protection. You have to possess faith in the stock's near-term upside for this trade to make sense.

 

KGCAt Expiry Gain/Losson Stock Value of$16 Call Value of$17 Calls NetGain/Loss
$20 $2 $4 -$3 x 2 0
$19 $1 $3 -$2 x 2 0
$18 0 $2 -$1 x 2 0
$17 -$1 $1 0 0
$16 -$2 0 0 -$2
$15 -$3 0 0 -$3

 

With gold's price currently reaching new highs, owners of laggard gold producers must now look to their stocks' bullion correlations to determine just how much faith they can reasonably muster.

 

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