Gold versus Gold Stocks

Gold has been on a tear recently. Not because of any real change in supply demand metrics. This is all about defensive positioning against a perceived devaluation of paper currency. In short gold bulls are playing the crisis insurance card… again!

I am not about to tell you to buy gold. I’ve talked about it in the past but to be frank there are enough writers willing to talk gold up. Many with solid reasons supporting their position. So let’s assume that you should have some gold in your portfolio. The question I want to tackle is whether you should gain exposure through gold or gold stocks.

The most basic argument would tell you to bypass the producers and hold bullion. You can gain exposure to bullion through ETFs or for those who prefer tactile pleasures, you can buy the actual bullion from your local bank.

When buying gold mining stocks you are assuming risks beyond gold’s price action. Miners are susceptible to company specific events like labor unrest, management expertise or lack thereof, leverage and margins which can impact your investment in up and down markets.

To add some meat to that last point, many gold miners engage in hedging strategies. As such rising gold prices will not necessarily result in better margins if management has hedged the company’s forward production. On the flip side, hedging strategies benefit investors by maintaining margins during periods when gold’s price is declining.

Since I typically move in and out of gold as a momentum play I tend to gravitate to gold miners. As a momentum play miners should move more dramatically because of the aforementioned leverage. At the most granular level, miners are in the margin business where proper analysis can assign reasonable probabilities. That’s easier than trying to explain the hedging dynamics used to talk up gold’s price during periods of financial uncertainty.

The fact that miners tend to be more volatile adds another twist when viewed in terms of the options market. Higher volatility translates in higher option premiums which can be useful when looking at option writing strategies.

For example, suppose you are looking for some exposure to gold as a hedge. Using miners you could write covered calls. As a case in point consider Agnico Eagle (TSX: AEM, Friday’s close $64.69) where we could buy the shares and sell the August 66 calls at $4.30. If AEM is called away at $66 per share the net two month return on the position is 8.6%.

Now let’s look at buying gold bullion trading at US $1,286 or CDN $1,650, as our hedge. To get the same two month return as our covered call on AEM gold would have to go to rally more than US $110 or CDN $170 per ounce. So what is the probability that gold rises by that much over the next sixty days?

The answer can be found in the option pricing formula… specifically the delta. The answer is that there is a 22.7% chance that gold will close above US $1,397 over the next sixty days. It may well do that but personally I like the odds associated with the AEM covered call where there is better than a 50% chance the shares of AEM will close above the $66 strike by the August expiration.