Bet on Barrick Gold

Barrick Gold Corp (TSX:ABX) has suffered the same consequences as many of its counterparts in the mining sector. To blame the most recent drop in gold would be misguided. While Barrick suffered a 33% drop in a little under a week on the heels of the gold sell off, the fact is that the downtrend was already well in place.

One concern for the fate of the mining sector sector is the increasing cost to pull the precious metal out of the ground. Some estimates suggest upwards of $1200.00/ounce, up from $400.00/ounce 10 years ago.

There are also numerous articles circulating attributing the stock’s decline to various fundamental issues including mine closures and other disappointments and setbacks. While these reasons are certainly important to consider, when reviewing the chart we can see that the shares are at levels that exceed lows dating back to 2000.

While the worst may not be over yet for Barrick, the current price offers an interesting opportunity to “buy when there’s blood in the streets”. While this presents a rather contrarian approach I believe the market does a really good job at overcompensating.

Most cautious investors would have a hard time putting up the capital to participate in a stock that not only does business in a market with significant uncertainty i.e. the future of gold, let alone one with significant fundamental concerns unique to the company itself.

This is where the option market shines. While the near term future of Barrick is admittedly questionable, an investor interested in locking in the purchase of shares at today’s price without putting up the entire amount of capital needed can consider using a call option with an expiration date greater than 1 year.

By purchasing a long term call option on ABX, the investor can lock in the future purchase of the shares at today’s price regardless of how high the stock is trading over the next year or so. This is accomplished with a greatly reduced commitment of capital.

For example, ABX is trading at $19.15 on the TSX currently (May 1, 2013). An investor wishing to buy 1000 shares would put up $19,150.00 to participate. Not only is the risk unidentified, but the investor has now tied up almost $20,000.00 for an unspecified period of time.

Consider the long term call option alternative. A January 2015, 19 strike call option is asking $4.40. An investor wishing to lock in the purchase price of 1000 shares of Barrick could purchase 10 contracts for a total of a $4400.00 allocation. This represents approximately 23% of the underlying share value.

To take it one step further, in margin account, the investor has the ability to sell short term call options against the longer dated call options. This is a form of Calendar Spread. To learn more about Calendar Spreads and variations of the strategy watch this video http://www.m-x.ca/video_details_en.php?id=143.

In this example, our strategy consists of buying a call option expiring January 2015 and selling near term, out-of the- money calls. This approach will help lower the cost basis of the longer term option month over month which will in turn lower the break even point of the position on expiration.

We would calculate the break even point on the trade by adding the $4.40 premium to the $19.00 strike. As a result, ABX shares would have to be trading above $23.40 if held to expiration.

Investors should note that a loss would be realized if the shares are trading below the breakeven point on expiration. Furthermore, The option will expire worthless if the shares are trading below the strike price.

As mentioned, we could significantly reduce this break even point by selling calls month over month. For example, The June 2013, 23 strike call is selling for $0.25. This is approximately 5.5% of the premium. With approximately 21 months until the January 2015 expiration, the investor can consistently collect a premium by writing calls against the option expiring in January 2015.

Of course no strategy is perfect. Investors should note that if the shares stage a significant rally beyond the written strike the option may have to be rolled to avoid assignment. If not managed properly, the investor may be forced to close the position resulting in a potential loss.

To take it one step further, at any point within the time frame of the trade, the investor can use some of the premium collected from call writing to purchase a short term Protective Put. This will offset a portion of risk during periods where there is an expectation of weakness.

Benefits of implementing this strategy include:

• Lower cost
• Identifiable risk exposure
• Reduced breakeven point
• Leveraged returns
• Less volatility then the stock position as the option will move at the rate of its delta
  

Options trading strategies such as buying a longer term call option and considering selling short term calls against it is a great alternative for investors who wish to participate in an opportunity at a reduced cost over a longer time horizon. The investor can benefit from a lower breakeven point and a monthly reduction in the risk exposure. To offset short term uncertainty, the call premium collected can be used to pay for a portion of the cost of protective put. This results in a short term hedge against a possible drop in ABX share value at a reduced cost.