Seeking Asymmetrical Risk/Reward in Barrick Gold

It is hard to deny that Canadian investors feel trampled and broken by the precipitous decline in the gold mining sector. Is it all over? Will gold stocks never go up again? Are all gold stocks destined to be bankrupt as gold will never again be used as a store of value? While anything can happen, it is far more likely that this great bear market in gold stocks will eventually bottom, and that presents a legitimate buying opportunity. It is sometimes helpful to look at the history of past gold bear markets to put this current one into perspective.

Just because gold stocks have declined so severely doesn’t mean that they are necessarily cheap, nor does it imply that they are guaranteed to go higher. In fact, there’s almost no certainty that the gold stocks can’t decline further. Does that mean that investors should not act on the opportunity in light of the risk?

This is where I find options to be strategically useful.

For this example, we will use Barrick Gold.

Here are the facts:

• Barrick (TSX:ABX) is trading at $21.45 (January 31, 2014)
• Barrick has a 52 week low at $14.22
• Barrick has a 52 week high of $33.49
• Barrick’s 2011 highs were at $54.32

For this example, our investor buys 1000 shares of Barrick for $21,450 on the belief that over the next 6 months gold will continue to recover toward its 52 week highs at $33.49.

So let us assess the risk. If proven wrong in having bought the shares, can our investor refute the risk exists that Barrick could return to its 52 week lows?

Many stock investors may find that proposition acceptable, but let’s take an opportunity to compare the risk/reward proposition if the investor used a 6 month call option as an alternative.

The investor buys 10 contracts of the July $22.00 calls for $1.86. This gives the investor the right to buy 1000 shares at the $22.00 strike over the next 6 months at an average cost of $23.86 ($22.00+$1.86)

The stock investor is risking $7,230 in order to make $12,040 in profit potential (1 : 1.67 risk : reward).

The options investor is risking $1,860 in order to make $9,630 in profit potential (1 : 5.18 risk : reward).

The key observations are that the options investor could experience a full $1,860 loss if the stock remains unchanged. At the same time, beyond the premium paid, the options investor is not exposed to any of the downside risk of the stock and therefore, if the shares drop to their 52 week lows, the investor can try again to buy the shares at the lows. Alternatively, the traditional investor has only the choice to dollar cost average a stock that is down over 30% from the entry price.

As a trader, if you cannot increase your probabilities of winning, you can at least ensure the opportunities represent an asymmetrical risk/reward proposition. In this case, if the trader’s outlook is proven to be correct, the call option gives the opportunity to make 5 times the amount risked.

Our readers would certainly ask the question, what is the downside to this approach? The key considerations have to be associated with timing. The share investor is not contained to any predefined time frame, while the option investor has to make a key decision to exercise or sell before the July expiration. Therefore, the option will always be best suited for objective based traders with a defined plan of action.