Think gold prices are headed lower? There are lots of ways to capitalize on such a move, and a purchase of the Direxion Daily Gold Miners Bear 3X ETF (NYSEARCA:DUST) is a popular play. Not only does DUST stock rise when gold prices slide lower, it does so without taking on a risky short position that requires a margin account. And, even though DUST stock is neither a future nor an option, it’s leveraged like one, moving three times as fast as gold mining stocks move, just in the other direction.
As it turns out, however, there are some scenarios where a position in the Direxion Daily Gold Miners Bear 3X ETF isn’t the soundest way to trade an impending pullback in gold prices, even if it is the simplest play.
Leverage Works Both Ways
A word of warning: The suggestion you’re about to hear won’t apply to some of you. It involves options, and if you’re not familiar with them, trading options in DUST stock isn’t the trade you want to use to cut your teeth.
Nevertheless, there are some speculative situations where the risk/reward ratio says you’re better off simply buying a call option on DUST stock, which offers greater reward and relatively limited downside.
The Q&D explanation of the Direxion Daily Gold Miners Bear 3X ETF is, for every 1% loss in the value of the NYSE Arca Gold Miners Index, the fund gains 3% in value. The reverse is also true. That is, for every 1% gain the NYSE Arca Gold Miners Index musters, DUST stock loses 3%. The moral of the story is, if you’re right, it’s rewarding, but if you’re wrong, it can be devastating.
Gold prices, and therefore gold mining stock prices, can move very quickly though, so if you’re on the wrong side of the trade and don’t realize it early on, it’s easy for your loss to grow to double digits in just a few days. Trading DUST stock is not for the faint of heart, particularly with the risk being as big as the reward.
What if, however, you could buy or sell DUST stock with less risk and even more potential reward? That’s what options can do in this case.
The Upside of Options for DUST Stock
The short lesson on options is, they’re the right to buy or sell 100 shares of a particular stock (or ETF) at a particular price, but not the obligation to do so. Call options give you a contractual right to buy XYZ stock at a set price, while put options give you the right to sell those 100 shares.
And they can be dirt cheap, if you’re willing to digest the possibility that you might lose a significant piece — if not all — of your option’s value. Thing is, it doesn’t take much money to make a lot of money with the right option.
Let’s use the DUST 17 Nov $26 calls for our example trade. Their current price of 90 cents, or $90 per contract ($0.90 x 100 shares) buys us the right to purchase 100 shares of DUST stock at $26 each — versus their current price of $23.80 — at any time over the course of the next month or so. Even if DUST flies to $30 per share, we can buy them at $26 and sell them at the then-current price of $30.
We don’t want to do exactly that, mind you. Our goal here is to just sell the 17 Nov $26 call for a profit. With DUST stock trading at $30 sometime in early November, the (theoretical) value of the call option in question would be right around $4.00 by mid-November. That translates into a net profit of $310 per contract — and that assumes the rally stops at $30 — or a 244% gain on our $90 investment.
Our maximum risk? Just the $90 we initially shelled to purchase the call option. Even if DUST stock falls to $19 per share, the most we can lose is that $90 per contract — we’ll just choose not to use it, as it would be fruitless to do so.
By comparison, the equivalent outright purchase of DUST stock would cost us $2380 ($23.80 x 100 shares). Should the fund move to $30, the value of our position moves to $3000, translating into a profit of $620.
Yes, that’s more than the $310 gain we reaped on the same move using call options. Put it in perspective, though. We tied up $2380 in capital by trading the ETF, and we only tied up $90 worth of capital by trading the option.
It’s also worth noting that had DUST fallen to $19, our $2380 investment in the Direxion Daily Gold Miners Bear 3X ETF would have fallen to a value of $1900. That would be a $480 loss, if you didn’t pull the plug any earlier than that.
There is a catch. The catch is, options expire. In the example above, the call options in question will be worthless by the third weekend of November. Any profit on the trade would have to be reaped before then, which means gold prices only have a month to fall and drive DUST stock — and therefore your call option — higher.
The limited-time nature of options, in this case, makes them ideal for hedging against short-term swings or taking advantage of gold’s ebbs and flows. But clearly, they’re not a long-term (or even intermediate-term) position. For some traders though, that’s perfectly OK.
To Buy or Sell DUST Stock?
Still not comfortable with the idea of a cheap option rather than an outright purchase of an ETF that, directionally anyway, is the same play? Don’t sweat it. They’re not for everybody.
Even if you aren’t comfortable with trading options though, it would be worth your time to paper trade them for a while, just to get a feel for how they work as a means of cheap insurance policies and low-cost speculations. Sometimes even a complete loss on an option trade is still less damaging than even a small loss on a comparably sized trade (in terms of the number of shares being put to work) of the exact same stock. But, you give yourself a chance for a sizable gain all the same.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter.