Thu Jun 26 2014
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The Gold Mining Play You Never Knew Was Yielding 37% a Year

Precious metals traded lower this spring as investors worried about the potential for interest rates to rise later in the year. After an unprecedented period in which the Federal Reserve has kept interest rates near zero and spent billions of dollars per month buying Treasury bonds, it is now making a calculated exit from its bond-buying program.

For investors in gold, one of the primary fears is that the Fed will allow interest rates to rise, which in turn, would lead to a stronger U.S. dollar. As a general rule, gold prices fall when the dollar is rising because a stronger dollar can buy more ounces of gold for less.

Last week, the Federal Reserve completed its scheduled meeting, and as expected, announced a fifth straight $ 10 billion cut in its monthly bond-buying program. While these cuts are widely expected to be bullish for the U.S. dollar, the Fed also issued a statement noting that it intended to keep the short-term interbank lending rate in a range of zero to 0.25% “for a considerable time after the asset purchase program ends.”

Prices for precious metals jumped on the announcement as it is becoming clear that the Fed will continue to be dovish even after it stops purchasing bonds on a monthly basis. Keeping interest rates near zero could potentially spark new inflation concerns, which traditionally is very bullish for gold prices. Traders are essentially getting ahead of the curve by going ahead and buying gold at current prices in anticipation of a more inflationary environment.

Gold mining stocks naturally reacted positively to higher gold prices. Junior gold miners in particular moved sharply higher because they are traditionally more sensitive to the underlying price of gold. While blue-chip miners typically have long-term selling contracts for the gold they produce, or other hedges in place, junior gold miners get hit harder when gold prices drop — and also stand to benefit more from rising prices.

Today, we have an opportunity to make a bullish bet on gold miners by setting up a put sellingincome trade that could generate 37% a year.

I expect gold prices will remain strong for the next several weeks and that junior gold miners will hold their recent gains and potentially add to them. The Market Vectors Junior Gold Miners ETF (NYSE: GDXJ) is a good proxy for this group, giving us diversified exposure to a wide number of individual miners.

Because of the recent volatility in junior gold miners, including a pullback on Tuesday, option prices are trading with higher premiums. This works to our favor as put sellers.

Specifically, I have my eye on the GDXJ Aug 39 Puts, which are trading near $ 1.97 per share. Each contract represents 100 shares, so by selling one contract we will be collecting $ 197 in income (less commissions).

When we sell these put options, we are essentially agreeing to purchase 100 shares of GDXJ per contract at the $ 39 strike price if the ETF is trading below this level when the puts expire on the third Friday in August.

I expect that GDXJ will remain above $ 39, but we still need to set aside enough money to cover our potential obligation in case shares are assigned. Since we will be receiving $ 1.97 per share, our net cost will be lowered to $ 37.03 per share, so we need $ 3,703 per contract of our own capital along with the premium we receive from selling the put contracts.

Assuming GDXJ remains above $ 39 and the puts expire worthless, our profit of $ 197 represents a 5.3% return over the $ 3,703 in capital we set aside. And since the puts expire in 52 days, our per-year rate of return actually nets out to 37%.

In GDXJ does pull back below $ 39, I would be happy to purchase shares at a cost basis of $ 37.03, which is below where the ETF was trading before the Fed issued its statement. And if we do get assigned shares, we will then have the option of holding for a rebound or sellingcovered calls against our position to generate more income.

Following the Fed’s most recent statement, it appears that precious metals should continue to move higher, and this income trade is a great way to capitalize on that trend.

Note: My colleague Amber Hestla has closed 52 straight winning trades using this strategy. You can see her entire track record and learn exactly how you can make the same winning trades yourself by following this link.

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