Uncover the Secret 39% Yield Buried in the Gold Mining Sector
As we head toward the end of the summer, volatility is once again entering the U.S. stock market. In late July, we saw a sharp drop in the blue-chip Dow industrials and broader market S&P 500. More speculative asset classes such as the small-cap Russell 2000 and high-yield bond market, which can be viewed via the SPDR Barclays High Yield Bond (NYSE: JNK) pictured below, had already experienced sharp declines well ahead of their higher-quality counterparts.
We have already covered how our put selling strategy benefits from an increase in volatility. To recap, increased volatility leads to higher options premiums, and this allows us to generate more income for our accounts when selling puts. Of course, we have to be more selective about which stocks we choose to sell puts against, but the added premium goes a long way toward offsetting our risk.
In addition to higher option premiums, another area that should benefit from an increase in volatility is the precious metals market. After an extended bear market that coincided with a steady grind higher for equities, gold and silver prices found support early this summer and rallied sharply.
Currently, precious metals are rising when fear enters the market and backing off when stocks begin rallying again. Given the length of time that the overall market has been in a bull trend, and the relatively high valuation levels, I’m expecting volatility in U.S. equities to continue to increase.
This should give us healthy levels of income as we continue to sell puts with inflated premiums, and we will pick our stocks carefully by focusing on those that have either found support or are in the process of rallying from minor setbacks.
Today, I want to take a look at a popular gold miner that has been in a healthy trend since the precious metals market bottomed. Shares of Barrick Gold (NYSE: ABX) hit a low near $15.50 in late May and have since traded materially higher to around $19. With the stock in a bullish trend and gold prices no longer in a bear market, this appears to be a good spot to pick up exposure.
In its recent earnings report, Barrick reported all-in sustaining costs, a comprehensive measure of the cost to produce an ounce of gold, of $865. While this was above the first-quarter level, the number came in below expectations. Management revised full-year cost expectations lower, and Barrick is perceived to have a strong portfolio of mines that produce gold well below the market price per ounce. This should allow the company to generate stable earnings going forward, which in turn, should boost shareholder confidence and the underlying stock price.
With the prognosis for ABX improving and traders supporting the price of gold, I want to set up an income trade by selling puts on the gold miner. Specifically, I want to sell the ABX Sep 19 Puts for a limit price of $0.65.
By selling these puts, we are agreeing to buy 100 shares of ABX per contract at the $19 strike price should ABX be trading below that level when the puts expire on Sept. 19. This price is just above the current level ABX is trading at, so there is a higher possibility than usual that we will end up owning the stock.
Since we are receiving $0.65 per share ($65 per contract) for selling these puts, our net cost will be lowered to $18.35 per share ($1,835 per contract). This is the amount of our own capital (along with the $0.65 in option premium) that we will need to set aside in case shares are assigned.
If ABX moves higher over the next five weeks, our puts will expire worthless and we will not be obligated to buy the shares. This is the best-case scenario for this position and would result in a 3.5% profit. The rate of return is calculated by dividing the $65 in income we receive from the puts by the $1,835 of our own capital that we will need to set aside in case our puts are exercised.
This will be generated in just 33 days, so our per-year rate of return nets out to 39%. While this trade has us taking on a bit more risk than some of our other put selling positions, the rate of return compensates us well for this risk.
One thing to keep in mind is that ABX pays a $0.05 quarterly dividend. So in the event that we wind up owning shares, we will be able to capture dividend income along with the income we received from selling the put contracts.
In 2013, Barrick paid a $0.20 quarterly dividend, but management reduced the payment as gold prices fell. Long-term investors have reason to believe that the company could increase its dividend again if gold prices rally, and this could help support the price of ABX.
Bottom line, the rise in volatility should lead more investors to hedge their exposure by allocating more capital to defensive asset classes such as precious metals. This should help support the price of gold miners. At the same time, higher volatility gives us the advantage of selling options at a higher price. Together, these factors make this trade a strong opportunity to generate a 39% per-year level of income.
Note: In addition to generating income by selling puts and collecting dividend payments, you can earn an extra 9%-plus a month from your stocks… by renting them out to other investors. To learn about this easy process, click here.