Catching Falling Knives

No sector has experienced more pessimism over the last year than the gold mining sector. This has left intelligent investors feeling like deer in headlights. Gold bulls will sight countless reasons as to why gold should be at $2,500 and why gold mining companies should be flourishing. Yet central banks around the world continue to adapt currency destructive monetary policies that can only continue to support the bull’s case. Under these circumstances gold should represent a store of value as investors grow increasingly skeptical of governments and central bank policies around the world.

So why are gold mining stocks doing so very poorly? One could never know for certain, but rational investors can site poor management, increasing costs, and lack of trend as viable reasons. I, on the other hand, primarily will point to the broader market conditions as the straw that broke the camel’s back. In a bullish environment where money is so openly being made in the markets, money managers cannot be left behind. Investors in mutual funds and hedge funds vote with their feet. If money managers cannot beat or meet market performance, money flows to follow performance.

If a sector doesn’t perform, investors sell the funds, fund managers sell the shares to cover redemptions, which drops them lower, which spurs a new wave of investors to sell and the death cycle continues. Investors stuck in this cycle continue to cling to the slippery slope of hope as rational logic is cast aside and manic depressive pessimism overshadows all investors.

Toronto is hosting the annual PDAC (Prospectors and Developers Association of Canada) conference. Anyone in attendance can immediately sense the desperation and pain being endured by the industry, even if masked by a smile. The conference is occurring at the same time as the many of the companies are trading at multi-year lows. Even the suggestion that investors should be buying gold mining stocks is immediately met with pessimism and reluctance. What better way to illustrate this than by looking at the gold miner bullish percentage index.

What this shows is that it is just a hair off zero. This index has been below 10 only twice before in the last 5 years. In each of those cases, the gold miners reversed and orchestrated material rally higher. Will this index go 3 for 3?

Catching falling knives is not for the faint of heart.

But for investors that utilize options as a tool, this represents a compelling opportunity. There are numerous alternatives on how to play this, but I want to utilize a short term strangle as a way to “catch a falling knife”. If you are unfamiliar with the strangle strategy, watch this short video: http://www.m-x.tv/media/straddles-and-strangles.

In this example, I am going to use the iShares S&P/TSX Global Gold Index Fund (TSX:XGD). To view the delayed quote and options chain, click http://www.m-x.ca/nego_cotes_en.php?symbol=XGD%2A .

• XGD is trading at $15.48 (3/8/13).
• The April $16.00 call is $0.30 and the April $15.00 put is $0.35.
• In this example I will buy both the $16.00 call and the $15.00 put for $0.65 net.

So what is the game plan?

If we did catch a bottom on the XGD, it will clearly rally above the $16.00 level, where I will exercise the calls to buy the underlying shares. My average cost on the shares would be $16.65.

If we are wrong or even just early and the XGD continues to free fall down to the $15.00 and $14.00 levels, we will be making money on the put as we lose value on the call. We will try to exit at break even or even try to make a small profit on the downside.

Let’s add perspective. The XGD was trading at $22.00 just 6 months ago and is now at its 52 week lows. If this is a bottom, a 50% retracement in the stock could see it trading at $19.00. At that time, I would physically own the shares and potentially be a long term investors.

If the ETF keeps dropping I am actually hoping it accelerates down where I can exit the strangle at break even or at a profit and later try again to catch the bottom with a brand new trade.

Worst case is that I lose $0.65 over the next 6 weeks. Something I am willing to risk versus taking on an undefined downside risk investors are exposed too.

I will follow up with a blog on this over the next month.