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It's been a disappointing winter for gold bulls. Despite the Fed's promise to keep rates at historical lows and to pump liquidity into the economy, precious metal prices have been trading steadily lower.
This may be due to the fact that all the good news was "priced in" a year ago. Often, markets move well ahead of actual fundamental pressures as traders anticipate them and place their orders in advance.
The stall in gold prices may also have come from "buyer exhaustion." Put another way, the majority of capital that could be invested in gold had already been put in play. So as some investors took profits, the price of gold and silver steadily pulled back from its peak.
Regardless of why gold prices have pulled back, the bottom line is that precious metals now appear to have found support and look to be setting up for another bull run. From a macro perspective, the Fed has not become more hawkish -- even with an improving economic picture -- and there are a number of global risks that could cause investors to resume gold purchases, driving prices higher.
Looking at the price action of gold miners, it is clear that investors are slowly regaining confidence. For the blue-chip miners that are closely tracked and actively traded, the price action has become much more constructive. With gold miners no longer making new lows, and many of them setting up very attractive basing patterns, I think it is a great time to start adding some exposure via a covered call trade.
Given the bearish action over the past several months, option traders are pricing in a higher degree of volatility, resulting in higher premiums for the option prices. This works in our favor because we are able to set up covered call positions with a much higher annualized rate of return.
Today, we're going to take a look at Agnico-Eagle Mines (NYSE: AEM), and I'm going to show you a way to create an expected 59% annualized rate of return, while once again taking on significantly less risk than a traditional stock investor.
Setting Up for a High-Probability Rebound
Agnico-Eagle is one of the better gold miners in terms of fundamental quality and geopolitical risk. The company operates mines in relatively safe jurisdictions and management focuses on organic growth rather than growth by acquisition. This means investors have to deal with far fewer nasty merger or government intervention surprises.
From a growth perspective, AEM continues to ramp up production. Last year, the company produced more than 1 million ounces of gold for the first time, and expectations are high for continued growth.
Of course, as covered call writers, we're not interested in holding AEM for years at a time, but it is important to buy stocks with a solid fundamental and price-action base so we can avoid the majority of situations where a stock breaks down and loses us money.
In the case of AEM, the stock has backed off to a very attractive valuation, and you can see on the chart below that buyers are stepping in to support the stock.
With a bullish backdrop in place for this stock, let's take a look at how we can generate 59% annualized returns by setting up a covered call trade:
At Monday's open, AEM was trading at $41.01 and the May $42.50 calls were priced at $1.45.
This means we can buy AEM at the market, and sell the calls to reduce our net cost per share to $39.56 ($41.01 for the stock less the $1.45 we receive for the calls). Remember, with covered calls we buy 100 shares at a time, and sell one call contract per 100 shares.
Under the best-case scenario, AEM will trade above $42.50 by the time the May calls expire. If this occurs, we will be obligated to sell our stock at $42.50, which means that we are able to book a profit of $2.94 on the trade. Compared to our net cost of $39.56, this represents a 7.43% return.
There are 46 calendar days until expiration on May 17, so when we run the numbers, we wind up with a 59% annualized return. Not too shabby!
Of course, while I expect AEM to trade higher, there is a chance that the stock could remain range-bound for a few more weeks. If AEM does not cross over $42.50 at the time our calls expire, then the calls will expire worthless, allowing us to keep our stock. Remember, we also get to keep the $1.45 per share that we received when selling these calls.
I wouldn't be disappointed with this outcome at all, because we could then turn around and sell more calls against this position, generating more income for our portfolio. Most likely, we would sell the June $42.50 or June $45 calls.
One thing to keep in mind is that AEM pays a quarterly dividend. The dividend won't come into play before the May expiration, but if the call options expire worthless and we continue to hold the stock, we will likely be able to collect a dividend payment on top of the income we receive for selling additional June calls.
In the worst-case scenario, if AEM falls, the options will expire worthless and the $1.45 premium will help offset the losses.
Assuming the market for precious metals and mining stocks continues to improve, I expect to have more trades for this sector. So stay tuned over the next several weeks as we keep tabs on the evolving dynamics for high-profile gold stocks.
As always, I'd love to hear what you think about this trade. Are you involved in precious metals? Do you have an opinion on the direction of gold and silver prices? Would you like to see more precious metal covered call setups?
Send you comments and questions to Editors@ProfitableTrading.com and mention this article on covered call writing. I look forward to hearing from you!
As a die-hard value investor, I struggled with its valuation in the past, but now I'm ready to pull the trigger.
Following a breakdown, there are simply too many bearish technicals on its chart to ignore.
As bearish trends take hold, this pick has become an overpriced company in a struggling sector.