You are here

The Alternative Gold Strategy That Could Yield 69% Annualized Returns

It was an ugly start to the week for gold stocks. On Monday, the price of gold dropped more than 8%, silver more than 12%, and precious metals miners took it on the chin as well.

News from Europe appeared to be the primary catalyst for the sell-off. The central bank of Cyprus is reportedly liquidating gold positions to raise funding, and investors fear other European countries could soon follow suit.

At the same time, hedge funds that are "long and wrong" are getting hit hard by the massive slide and are selling positions to stem their losses. This has resulted in a vicious circle where lower prices trigger more selling, which then leads to still lower prices.

Basically, with gold prices getting rocked over the past week, we've got an opportunity to buy gold miners at a tremendous discount. I'm particularly interested in the Market Vectors Junior Gold Miners ETF (NYSE: GDXJ), because the junior miners have so much leverage to the price of gold.

When things are bad for gold, the junior miners feel the pain most acutely. On the other hand, when gold prices rebound, the junior miners are typically the first to follow suit.

For the average investor, volatility is a four-letter word. In fact, financial academics actually use a four-letter word to characterize volatility: risk.

Unfortunately, most investors don't realize that volatility is actually synonymous with opportunity. Of course, you always have to manage your risk carefully, but without volatility, there wouldn't be an opportunity to beat the market by generating oversized returns.

For covered call traders, in particular, volatility is a special gift. You see, when volatility increases, the price of options (both call and put contracts) also increases. This gives us a chance to get much more protection (and more income) by selling calls at a much higher price.

That's exactly the kind of opportunity we have today as we set up our covered call trade for GDXJ.

I'll admit that the chart below isn't pretty. GDXJ has been in a bear market for quite some time. But notice that each time it has a major break lower, the next few weeks result in a rebound -- or at least a stabilization of the price action.

GDXJ Chart

GDXJ is currently trading near $12.15 per share. We're going to buy the stock in 100-share lots and then sell the GDXJ May 12 Calls against the stock.

The May $12 calls are currently trading for about $0.80 per share. Remember, each call contract represents 100 shares, so you will want to sell one call contract for every 100 shares of GDXJ that you bought.

The beautiful thing about the recent volatility is that the calls are priced much higher than they typically would be in a stable market. In fact, our net cost for the trade will be $11.35 per share -- meaning GDXJ would have to drop another 6.6% in the next 30 days before we would recognize a loss on the position. How's that for protection?

Over the next few weeks, I expect GDXJ to rebound. The entire gold complex is very washed out and due for a turnaround. One could argue that we've seen the "worst-of-the-worst" environment, and that anyone who is predisposed to sell has already pulled to the trigger at this point.

To be clear, we don't actually need GDXJ to rebound in order to recognize our maximum profit on this trade. As long as the ETF simply stabilizes and remains above $12, we will be obligated to sell our stock at $12 per share. Since our net cost for the position is $11.35, we will be capturing a profit of $0.65 for a return of 5.73%, excluding commission costs.

A 5.73% gain may not sound like much, but keep in mind that we would be booking this gain in a 30-day window. If you annualize this return out over a full year, it represents a 68.8% annualized return. And if GDXJ does continue its slide, the premium collected from selling the options helps to offset the loss.

With our covered call strategy, we find one or two opportunities like this each week and put them into our portfolio. When the calls are exercised, we turn around and plow our capital into the next opportunity.

Over a year's time, there are dozens and dozens of opportunities like this, and we take each one from a position of risk control -- protecting our positions so that even if the stock doesn't move in our favor, we still have much less at risk than a typical investor.

Sure, this strategy misses some great opportunities to pick just the right tech stock that rallies for 100% over a six-month period. But it also avoids the heartache when that same stock comes crashing back to Earth.

What's more exciting anyway, telling your friends that you booked 35% to 50% over the last year in cold-hard-cash earnings, or telling them about a roller-coaster ride you took on a hot stock tip? I'll take steady, market-beating gains any day.

At any rate, I hope you're enjoying the covered call recommendations we've been offering and have had the chance to capture gains on a number of our picks.

This Friday is options expiration for April contracts. Later this week, I'll send out an update for all of our April positions, and give you some ideas for how to proceed with these positions. As always, I enjoy hearing from you. Just send an email to Editors@ProfitableTrading.com and mention the covered call articles.