Profiting from the Precious Metals Sector…
Commodities / Gold & Silver Stocks Aug 29, 2009 - 09:42 AM GMT
In keeping with our recent theme of generating income from gold and gold share investments, we now continue with the final installment in our series. We trust you found the first two parts helpful, the former on convertible gold securities and the latter on covered calls.
This week we take a slight departure from the income generating theme, insofar as the strategy we'll be outlining is not one that generates income per se, though it can generate nice profits. It is also not a strategy that is conventionally used in the investment world, though it certainly has its devoted band of trusting adherents. The technique involves the simultaneous buying and selling of options and is referred to as a 'zero-premium' sector trade. Below, we show you how it works.
Long-Short Hedge Funds
A popular hedge fund strategy involves being both long and short certain stocks in a particular industry. The idea is simple: by buying the best gold company, for instance, and shorting the worst, one can create what traders refer to as a 'market neutral' trade. That is, when gold stocks rise, the best company will rise more rapidly than the worst, and when the sector falls, the bad outfit will fall more rapidly than the good. The difference in performance between the two stocks is the trader's profit.
Our trade is a variation on this theme. But we also have a secondary aim: to pay as little as possible (or nothing) to initiate the trade. This is why it is referred to as a 'zero premium trade.'
How does it work? With the precious metals, there are a number of possibilities:
- Buy a call on the best performing gold stock and sell a call on the worst performer, using the cost of the respective options as our guide in determining which strikes to buy and sell (see example, below), or
- Buy a call on the best performer in the gold sector and sell a call on a gold index (here there will be differences of opinion over which index to choose, but I would hazard that XAU is the least volatile of the generally recognized gold indexes), or
- Go long calls in the best silver performer and short calls in the worst gold. This trade is predicated on the assumption that silver has a more volatile trading pattern, and generally outperforms gold in percentage gains when there's an overall spike in the value of precious metals.
The point here is that there is no limit to the number of combinations one can conceive to execute the trade. Our goal is simply to find the safest. And here, too, surely, there will be a range of opinions on the matter.
Remember: all that needs to happen for the trade to be successful is to have the better stock outperform the worse.
Let's look at one possible trade to get a sense of how it actually works when the shooting begins.
The following chart shows the relative performance of two precious metals stocks alongside the XAU for the last three months trade.
Stillwater (NYSE:SWC) is a platinum producer with operations centered in the U.S. west and Coeur D'Alene (NYSE:CDE) is a major silver producer with properties strung up and down the Americas.
What's important to note here, however, is the recent outperformance of Stillwater.
That said, let's turn to the options.
Stillwater closed yesterday at $6.83 and her September $7.50 calls can be purchased for $0.35.
Coeur closed yesterday at $16.01, and her September $20.00 calls can be sold for $0.35.
The trade:
Buy 20 Stillwater September $7.50 calls, and sell 20 Coeur September $20.00 calls for a net cost of nothing to you (before commissions).
Between now and the third Friday in September (when the options expire) your profit will be the relative outperformance of Stillwater shares over Coeur's.
Risk – Reward Breakdown of the Trade
Three possible scenarios have to be investigated.
- First, Stillwater outperforms, rising, say, 20% to $8.20 by expiration. Coeur rises only 15% to $18.41. The long call (SWC) is valued at $0.70 (8.20 - 7.50), while the short call (CDE) expires out-of-the-money, worthless ($18.41 vs. $20.00 strike). Your profit is $70 per option, or $1400 ($70 x 20). Pretty good for a net investment of $0 (less commissions).
- You are correct, but by expiration neither Stillwater nor Coeur manages to rise above its strike. Both sets of options expire worthless, and your loss is the amount of commissions paid.
- You are wrong, and Coeur outperforms Stillwater. Now you could be in trouble. If this becomes apparent before expiration, you'll have to unwind the trade, particularly if Coeur moves into-the-money before Stillwater. At that point, the Coeur options will likely increase in value faster than Stillwater's.
To illustrate the point, say Stillwater rises 15% to $7.85 and Coeur rises 28% to $20.49. At that point the long option will be worth $0.35 (7.85 – 7.50) and the short option will be worth $0.49 (20.49 – 20.00). There will be a net loss of $0.14 on each pair of options, or $280 ($14 x 20). Best to close up shop at this point with a negligible loss and look for new opportunities.
Jumping on the Opportunity
If you've done your homework and you're prepared to monitor the trade closely, the zero-premium sector trade has great advantages. First it's cost-free (relatively speaking). It also matters little what the broad market is doing – or the sector – since the trade's sole profit determinant is the relative outperformance of a single stock.
Moreover, it can be set up on the downside, too. That is, if both stocks move south and their respective call options expire worthless, you can still profit if you've worked the identical trade with puts (time and space restrictions mean you'll have to figure that one out for yourselves).
On a negative note, your brokerage may require you to put up significant margin to cover what they consider the 'naked call' on Coeur.
The Residual Income Report recommends subscribers buy 20 Stillwater September $7.50 Calls (SWCIU)and sell 20 Coeur September $20.00 calls (CDEID) at zero cost, net.
And steal your profits!
Matt McAbby
Analyst, Oxbury Research
After graduating from Harvard University in 1989, Matt worked as a Financial Advisor at Wood Gundy Private Client Investments (now CIBC World Markets). After several successful years, he moved over to the analysis side of the business and has written extensively for some of corporate Canada's largest financial institutions.
Oxbury Research originally formed as an underground investment club, Oxbury Publishing is comprised of a wide variety of Wall Street professionals - from equity analysts to futures floor traders – all independent thinkers and all capital market veterans.
Copyright © 2009 Oxbury Research - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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