Solid Gold!

Low interest rates, rising inflation, and a lower US dollar combined to lift the price of gold for the fourth straight week. With the Fed openly talking about another round of quantitative easing the interest in gold as a hedge and as a speculation jumped right along with its price. Gold ended the week at US$1,738 per ounce, up 4.4% on the week, and ahead 11% since the beginning of the year.

With interest in gold rekindled, interest in gold mining has also stirred. Year to date the S&P/TSX Global Gold Index is up 8.9%. With the Fed committed to a regime of easy money and inflation for the foreseeable future, implying a weaker US dollar, the price of gold should continue to find momentum this year.

Analysts often note how gold mining companies typically lag the performance of gold bullion. You can see evidence of that in the accompanying chart which examines the one year performance of Goldcorp relative to the performance of gold bullion (as shown in the gold line representing the price action of GLD, the ETF that tracks the price of gold bullion). Typically when miners finally catch fire, they tend to outperform bullion prices because of the inherent leverage in the business model.

The short-term disconnect between gold miners and gold bullion makes sense when you consider that gold mining companies get no real benefit from short-term spikes – or suffer any real detriment from short-term sell offs – in the price of bullion. Rather they benefit – or suffer – based on the longer term trends in gold’s price and whether those trends are sustainable.

When the US Federal Reserve (Fed) announced, after last weeks meeting, that interest rates will remain extraordinarily low well into 2014, and that a third round of quantitative easing was a possibility – even likely – if the US economy showed signs of slowing, investors were suddenly convinced that the rise in bullion was real and sustainable.

Taking that thesis full circle, Goldcorp (TSX: G, Friday’s close $49.22) is a well positioned Canadian miner that can take full advantage of higher gold prices. Goldcorp expects to produce 2.6 million ounces of gold in 2012, with costs of production somewhere between US$250 and US$275 per ounce on a by-product basis. That makes Goldcorp one of the lowest-cost producers in the world. And with gold at US$1,738 per ounce, one might argue the company is minting money.

The company is also sitting on a mountain of cash estimated to be north of $1.476 billion. While the shares have rallied 8.9% since the beginning of the year, they are still considerably off of their 52-week high of $55.93. Traders who believe gold is at the start of another leg up might consider bullish options positions on Goldcorp in anticipation of further price advances.

The challenge for traders is the high cost of trading options on gold mining companies. When you look at historical price patterns for the gold miners you see a sector in which the shares experience higher than average intraday volatility but rarely make significant moves one way or the other. As such, options on gold stocks regularly trade in the top quartile of implied volatilities.

That said, there are windows where the shares of gold mining companies vault to the higher end of their trading range, which if applied to Goldcorp, would be the aforementioned 52-week high of $55.93. Combine that with periods where gold mining stocks have traded in a narrower range, leading to a decline in the implied volatility numbers, and you have a combination where going long calls as a short term speculation has merit.

Aggressive traders might want to consider buying short-term Goldcorp calls to take advantage of this change in sentiment. Specifically look at buying the Goldcorp March 50 calls at $1.80.

Another approach that is less aggressive is a bull call spread. In this strategy you would buy the Goldcorp March 50 calls at $1.80 while selling the March 56 calls at $30 cents per share. The net cost of the spread is $1.50 per share with a maximum profit of $6.00 per share (difference between the two strike prices $56 – $50 = $6.00) should Goldcorp breech its 52 week high.