Stock Recommendation: Buy the MarketVectors Junior Gold Miners ETF (NYSE:GDXJ)
Option Alternative: Buy to open the February 22 GDXJ calls
Gold mining companies can be split into the large “majors,” like Barrick Gold Corporation (NYSE:ABX) and Goldcorp (NYSE:GG) with market capitalizations above $10 billion, and the smaller “juniors” that have concentrated exposure to a few geographic areas. The lack of global diversification adds to their currency risk and average volatility — but for investors willing to take this risk, the potential returns can be much greater.
Gold bullion prices have been stuck in a sideways channel since the August 2011 debt-ceiling dispute, but it looks ready to break following the recent inverted head-and-shoulders pattern in the spot price. We expect the coming rally to be particularly productive for junior miners.
Inverse Relationship Between Gold and the Dollar
Click to EnlargeWhen investors become nervous about a spreading credit crisis, they tend to buy the dollar and sell everything else, and a rising dollar will drop gold prices because gold is priced in dollars. This is particularly problematic for junior gold producer stocks. They tend to struggle against a strong dollar because of their potential currency risk.
It doesn’t take a large shift in the dollar’s value to create big gold gains. During the July-September gold rally this year, the S&P 500 rose 6.5%, gold mining majors rose 18% and gold mining juniors rallied 27%. The U.S. dollar only dropped 2.5% during that period. The dollar is likely to drop like that again in the short term because of an improving outlook for the fiscal cliff in the U.S. and a temporary resolution to the bailout issues in Greece.
And once those crises cool off, gold will likely do well. Traders like to use it to offset the effects of inflation on their stock and bond holdings; and with an endless round of quantitative easing, they’re hedging against inflation now.
The Gold “VIX”
The other factor for gold is its historical relationship with its implied volatility.
Options on the SPDR Gold Trust (NYSE:GLD), the largest gold ETF, are used to create a volatility index of gold, the CBOE Gold Volatility Index (CBOE:GVZ). The difference between the VIX and GVZ is that for GVZ, higher levels of volatility can indicate the potential for higher prices rather than the other way around. So when the GVZ reaches extremely low levels, we look for a pop in gold’s price.
Click to Enlarge As you can see in the chart, GVZ is near all-time lows. The last time GVZ approached this level and gold prices were rising was August of this year. That was just as the rally in gold juniors was getting started — the rally that created 27% in profits. This inverse relationship occurs because gold tends to “crash up” when sudden changes occur. This is the opposite of stocks that “crash down” when something fundamental changes in the market.
The junior miners over the last year or two have struggled during downturns due to operational problems among some big components in the industry. For example, Jaguar Mining (NYSE:JAG) had production levels implode about a year ago. The stock price dropped by 90%, which dragged down the entire group.
Stock Recommendation: MarketVectors Junior Gold Minders ETF (NYSE:GDXJ) should provide some protection against the risk of individual mining companies experiencing a catastrophic loss. The expense ratio is a little high compared to gold bullion ETFs like the SPDR Gold Trust (NYSE:GLD) or the iShares Gold Trust (NYSE:IAU), but the potential upside is also much larger. The ETF will help spread the risk across a broad spectrum of North American, Chinese, Australian, and South African stocks. That kind of international exposure gives us the potential double benefit of rising gold prices on economic optimism and a falling dollar.
We recommend buying GDXJ as it is currently retesting support at $22-23 per share. Our short term target is September’s high at $25 per share, but momentum could take it to last January’s highs near $30.
Options Alternative: Buy to open the GDXJ February 2013 $22 Calls for $1.50 per share or less.
We expect the initial move to $25 well before expiration, which will make this leveraged trade very profitable in the short term. Open interest in the forward months is heavily biased towards calls, which leans towards a bullish outlook among option traders. Because implied volatility levels are low the options are currently at an attractive price.
John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.