You are here

Blue-Chip Gold Stock Could Yield 78% a Year

If the recent feedback from readers is any indication, investors are paying close attention to the action in gold stocks -- and are excited about taking advantage of the recent discount in prices.

Two weeks ago, precious metal prices took a sharp fall on news that European governments may be liquidating gold positions to raise needed funds. In addition, a number of hedge funds have been selling out of losing gold positions, creating a wash-out for prices.

Since the carnage on April 12 and April 15, precious metal prices have stabilized and begun to recover. Stock prices for precious metal miners have also found a floor, and investors are once again plowing capital back into the area.

I'm seeing more opportunity in gold miners -- both because of the improvement in the price action and because of the high options premiums related to the volatility. Remember, when stocks are more volatile, option traders pay a higher price for call and put contracts, which works in our favor when setting up covered call positions.

Today, we're going to take a look at another great opportunity to generate healthy profits on a gold miner, while adding protection against the volatility in the sector.

A Word of Caution

Whenever I see a large number of traders get excited about a particular industry or stock, my instincts tell me to be careful. Too many short-term traders on one side of a particular market can be a recipe for disaster, so it pays to use caution in these instances.

The situation for precious metals (and precious metal miners) is still fluid. There are many uncertainties, and we can expect more volatility over the next few months, but volatility is always the highest at key turning points.

With that said, I do think that covered call positions in precious metal miners represent a tremendous trading opportunity. But I want to trade them within the context of a well-balanced portfolio. That means I am also excited about our other trades for retailers, drug companies and social media plays.

If you are only trading the gold miner positions that are recommended, you are taking on more risk in your trading approach. There is nothing wrong with taking this risk, as long as you know that your success or failure at this junction rides on the price action of precious metals.

This is an area I definitely think we should be involved in, but please manage your capital carefully and don't bet the farm just yet.

Barrick Gold -- A Turnaround Story

Today's trade is Barrick Gold Corp. (NYSE: ABX). Barrick is one of the largest blue-chip mining companies trading on U.S. exchanges, and one of the biggest turnaround stories in the market right now.

To make a long story short, Barrick has totally mismanaged the company during the past few years. With the price of gold rising, the management team decided to plow capital into speculative mines around the world, and accept higher production costs, because they could afford them with the spot price of gold rising.

As gold prices have pulled back over the last few quarters, Barrick has started to feel the pain. Speculative projects have hit snags, and geopolitical risk has come into play. Investors have dumped the stock because of the poor performance, and the price has fallen sharply.

Last year at this time, Barrick was trading near $40. And two years ago, the stock was closer to $55. Today, you can pick up shares for $19.06 -- an extreme discount.

The good news for Barrick is that management has finally woken up to the fact that they need to have tighter controls on their operations. Within the past two quarters, management has made some dramatic changes to the company's capital structure, allocating funds only to established mines in stable regions.

This new direction will be a tremendous benefit to shareholders because the company will no longer be throwing capital at wasteful projects. More importantly, Barrick does not hedge its exposure to gold prices. So while the company certainly got hurt during the past two weeks when gold prices took a nosedive, it also has more to gain as gold prices recover.

If you take a look at the daily chart for ABX, you'll notice that the stock has been trading in a much more stable pattern after finding a floor last week.

ABX Stock Chart

It wouldn't surprise me at all to see the stock trade back into the mid-$20s over the next few weeks as buyers come back into the precious metal market. But for our purposes, we don't actually need ABX to rebound. We simply need it to hold steady at its current price, and the option prices will do all the work for us.

Here's how to set up the trade:

-- Buy ABX in 100-share lots (you should be able to pick up shares near $19.06)
-- Sell the ABX May 19 Calls near $0.91 (one call contract for every 100 shares of stock)

The net cost of this trade comes out to $18.15 per share ($19.06 less the $0.91 for the calls). Over the next 22 days, the buyer of these call contracts will have the right but not the obligation to buy ABX from us at $19.

Assuming ABX remains steady (anywhere above $19 per share), we will be obligated to sell the stock at $19 on May 17. This means we will realize a profit of $0.85 per share over a 22-day period. On a nominal basis, this represents a 4.7% gain. And if you were to repeat a similar trade every 22 days, you'd get a 78% return per year.

Of course, there is no guarantee that ABX will remain above $19. But even if the stock pulls back between now and the expiration date, we will have the option of selling more contracts and collecting additional income while waiting for the stock to rebound.

Are you putting this trade in your account? Do you have a favorite stock that you would like to see outlined as a covered call setup? Send me an email (editors@ProfitableTrading.com) and mention the covered call articles.