Will Gold Begin to Glitter Again?

Gold has been in a material bear market for over 2 years. We have now seen some capitulation selling that has seen gold print below $1200.00 in late June. Since the low, gold has been retracing back to its 50 day moving average, which has been resistance for its entire decline during 2013. After such a prolonged bear market, it is common to see a commodity develop a new price base. We will be tentatively watching to see if gold can develop that longer term base from which we could see a new uptrend emerge.

What we find particularly interesting is the material drop in COMEX Gold Exchange inventories, as reported by Bloomberg. Traditionally, in the commodity markets, the price drops because supply and inventories rise. Instead, over the last year we have seen gold prices plummet at the same time as inventories are dropping near decade lows as gold miners are aggressively shutting down mines.

Something has to give.

Either gold will rise due to supply shortages or a new supply of gold will emerge. A new supply is likely not coming from an expansion of mining projects, as almost all gold miners are cutting production back with massive balance sheet write downs.

Canadian investors tend to be more interested in the gold story then the average international investor, as we have the most robust resource markets for raising capital for junior and senior mining and exploration projects. This makes the drop in gold far more relevant to the more sophisticated Canadian investor.

So what to do?

Making a bold investment in gold without a definitive catalyst for new uptrend has its risks. When a market is already weak, it is most vulnerable for further bear attacks. So, investors wanting to make a longer term stake in the precious metal can consider utilizing an options strategy to accumulate the position.

iShares has a Canadian Gold Bullion Fund (TSX:CGL) last priced at $11.76. To read the details of the ETF visit http://ca.ishares.com/product_info/fund/overview/CGL.htm

The Montreal Exchange lists options on the CGL. We want to explore the idea of buying a call option as a strategy to accumulate a position if the ETF continued to advance while providing a risk managed way to participate.

In this example, the investor wants to consider accumulating 1000 shares and is going to use an in-the-money option to take their initial stake. If the investor purchased the shares, it would require the upfront investment of $11,760.00. From a risk perspective, if the investor was early to this story and gold proceeded to drop again, there is an undefined downside risk.

Alternatively, you can use this options strategy:

TSX:CGL is at $11.76

Buy 10 October $11.00 call options at $1.00 ask ($1,000.00).

Investors have until October to decide if they will exercise the option and take ownership of the shares at the $11.00 strike ($12.00 average cost base).

If gold was to have a material drop, the option declines only at the rate of the delta to a maximum risk of $1.00 per share or $1000.00 gross. This means that the investor has 100% of the upside of gold but, if wrong, is losing at a diminishing and limited rate. Finding asymmetric risk/reward propositions is always an objective of any astute investor.