Bullish Outlook

Gold Covered Straddles

Richard Croft
May 9, 2016
5 minutes read
Gold Covered Straddles

I talked about gold… reluctantly, back in February. I also read with interest comments from Patrick Ceresna who, also in February, penned a two-part thesis on why gold should move higher. And Patrick provided some strategies for investors to take advantage of his bull case which, I might add, have paid off handsomely.

I also penned a bull case… again reluctantly. And in the process chose a more conservative approach. If you followed our lead in February, you should be quite happy. If you are not happy because you thought a more aggressive strategy would have produced a better payoff well that’s a negative behavioral issue that you might want to reassess. But enough about investing psychology.

The debate at this stage is whether gold stocks, which have risen in percentage terms significantly more than bullion, are in the early stages of a longer term uptrend or have they been the beneficiary of a short term blip caused by a secular rotation into precious metals. It is an interesting question which I will leave for those who have more insight into the world of gold aficionados.

For those who want to play the gold card but share my reservations about jumping on an emotional roller coaster, consider employing the covered straddle as a way to enter the game. I have talked about this recently when looking at volatile elements within the market. And for gold stocks, volatility is the one factor that exists with certainty.

To that point, it is interesting to note that gold stocks tend to be more volatile on the way up. That is diametrically opposite to what we see in other sectors where volatility rises when stocks fall. The covered straddle takes advantage of this anomaly.

The idea is to buy an underlying gold stock and write a call and put on the shares. If gold stocks rise – in keeping with the longer term uptrend thesis – the shares will be called away and you would have captured two option premiums trading at above average implied volatilities.

If gold stocks decline – in keeping with the secular rotation thesis – you would be able to average into a position at a more reasonable price point. Probably averaging down your cost base to prices that existed prior to the recent surge.

To make this case I will look at a couple of examples. Obviously feel free to apply the strategy to your favorite gold stock because the numbers will look similar to the following examples.

With that in mind let’s examine Goldcorp and Barrick Gold as case studies. Arguable two of the more poorly run gold companies.

With Goldcorp (TMX: G, Friday’s close $24.78), we will buy 500 shares and write the October 24 calls at $2.55 and October 24 puts at $3.35 for a net credit of $5.90 per share. If Goldcorp stays the same or rises by the October expiration your shares will be called away at $24 per share. The October 24 puts will expire worthless and your six-month total return on invested capital (I assume you would use margin to carry the short put) will be 20.7%.

If Goldcorp is trading below $24 at the October expiration you will be required to buy another 500 shares at $24 per share. The short calls will expire worthless. The average cost for 1,000 shares at that point would be $21.44 which is about where Goldcorp was before gold took off.

Barrick Gold (ABX, Friday’s close: $23.83) produces similar results. Buy 500 shares of ABX and write the ABX October 23 calls at $3.35 and the ABX October 23 puts at $2.50 generates $5.55 in premium income. If ABX stays the same or rises the six-month return on invested capital is 19.6%. If ABX declines the calls will expire worthless but you would be obligated to buy an additional 500 shares at $23. Your average cost for 1,000 shares would be $20.66. That’s above the price at which ABX was at in mid-March mainly because ABX had a stronger rally related to company specific issues. But it still passes muster when considering you are a late entry into the gold story.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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