Is Barrick Gold an Opportunity?

This morning, in the Financial Post’s Business Insider editorial they featured forecasts on the 14 major commodities and how the will do over the next two years. While many of those commodities were referenced as being in high inventory and excess supply, one commodity stood out. They suggested that gold is still a good bet referencing that further quantitative easing from the Fed and the ECB’s unlimited bond purchase program are likely to be good for gold prices suggesting a 2014 projected price of $1800/oz. http://business.financialpost.com/2013/01/25/how-the-14-major-commodities-will-do-for-the-next-two-years/

Astute investors immediately recognize that the majority Canadian gold mining stocks continue to trade near multi-year lows and ask the question as to if this is an opportunity for an investment? Today we want to debate- if an investor was looking to buy Barrick Gold, should a call option be considered as an alternative and what should be taken into consideration for strike price and time frame selection.

Considerations:

1. Barrick Gold is at $33.13 at the time of writing (1/25/13).
2. The 52 week swing low for Barrick was $30.66.
3. The two key swing highs for Barrick in 2012 were $42.94 and $49.43.
4. The VIXC is trading at 5 year lows meaning that volatility premiums on options are historically low.

If volatility was high we would have considered a number of more sophisticated options strategies like spreads or a butterfly, but with very low volatility premiums like we see today, there is merits to keeping it simple and just buying a longer-term call option.

Here is what we know:

1. The last several times that Barrick has started a bottoming process and subsequently rallied, the process took as much as 3-6 months to play out (trough to peak).
2. If a rally was to occur, it would not be an unrealistic goal for investors to target the September stock highs at $43.00 as a target for a new upside move.

So what strike price and month can an investor consider?

What month?

Since investors today cannot definitively say that Barrick is at the bottom, we can immediately rule out February, March and April call options as reasonable investment vehicles for participating in an up cycle on the stock. This leaves us to have to pick between July or January 2014 options. Because it will not take an entire year to find out if this was a good trade idea, the July call options appear as a reasonable proposition.

What strike?

Normally we could consider out-of-the-money options, but because the implied volatility of the market is so low, the premiums on barrick options are very reasonable for the at-the-money $34.00 strike which was at $1.75 per call option (at the time of writing). One of the considerations here is that if a sudden spike in volatility was to occur because of a yet unknown catalyst, we could gain a nice pick up in the value of the option even if the stock does not change in price. If you would like to better understand the impacts of volatility on your options price, reference this short TMX video: http://www.m-x.tv/media/how-volatility-influences-your-option-value

The $34.00 July at-the-money call gives us a very good risk/reward proposition. Each call option will cost $175.00 and control $3,300.00 (100 shares) of barrick gold shares.

Scenario 1: Barrick continues to decline in price.

Under this scenario Barrick trades lower over the next two months toward $29.00. We would likely see the option trading in the $0.65-$1.00 range. We would likely cut our losses in the $100.00 per contact range and now consider a new opportunity elsewhere. To put that comparatively into perspective, an investor that was long the stock would be down $4.00 a share and be faced with the decision as hold it long-term or to cut ones losses.

Scenario 2: Barrick proceeds toward the September highs.

Under this scenario Barrick trades back toward the $43.00 highs it made back in September. A stock price move like this would see as much as $9.00 of intrinsic value build into the option price as the investor has the right to buy the shares at $34.00 and could subsequently sell them at $43.00. This leaves $7.25 profit potential after taking account for the $1.75 cost.

When assessing the risk/reward, for every call option purchased the investor is risking $100.00-$175.00 for an upside potential as high as $700.00+. While we cannot suggest that Barrick will meet the upside objective, investors that feel strongly about Barrick’s stock direction could find the call option as a good alternative to owning the shares at these levels.

Patrick Ceresna, CMT CIM DMS