Last week’s spike in the price of gold generated a lot of buy-side activity in the metals and mining sector. The S&P/TSX Metals & Mining subindex advanced 5.4% on the week, second only to the 8% jump in the Energy subindex.

Miners like Goldcorp Inc. (TSX: G, Friday’s close $44.48) have seen share prices spike considerably since the beginning of the month, along with sector index funds such as the iShares CDN Gold Sector Index Fund (TSX: XGD, $21.66), the iShares S&P/TSX CDN Materials Sector Index Fund (TSX: XMA, $17.20), and the iShares CDN Energy Sector Index Fund (TSX: XEG, $17.82).

One could argue that gold is moving higher on the back of supply and demand issues. Relatively tight supplies to offset rising demand from China and India supported by their desire to hedge against a weaker US dollar.

On the other hand, hedging your bets at this stage is not the worst decision you could make. Particularly if you are already long these sectors. The easiest way to hedge sector ETFs is to purchase protective puts. Generally, writing options on sector ETFs does not provide sufficient balance between downside protection versus upside limitations. With the possible exception of XGD.

In terms of XGD and individual stocks, the covered call strategy provides a reasonable balance. With individual stock options, you capture the volatility inherent in the sector as well as the individual stock.

As for XGD, because it tracks so few large gold mining companies which tend to follow similar patterns - last weeks price action on Barrick Gold notwithstanding - you do not get the same volatility dampening affect that tends to impact most sector ETFs.

The XGD October 22 calls at 80 cents seems to provide a reasonable balance between upside potential, cash flow and downside protection. In terms of the individual stocks, I would look at writing Goldcorp October 46 calls at $1.50.

Speaking of Barrick (TSX: ABX, $41.17), I would expect the options on this company to imply higher volatilities going forward. Last week, at great cost, Barrick bought back their forward contracts, which obligated the company to deliver gold at prices below current market values.
Obviously the company believes gold is going higher and wants to see that revenue flow to the bottom line. But it also means that Barricks’ share price will become more susceptible to gold price variability, and I would expect that to be priced in the options.

Answering Comments:

I always enjoy receiving comments and questions from the blog. Three comments were posted related to the “Understanding Volatility” blog. One from Vlad asked whether the premium on 8% to 10% out-of-the-money calls on XIU was enough to compensate for the cost of trading options.

In fairness, I am not sure that the premium for far out-of-the-money calls on any ETF makes sense from a covered call writing perspective. When dealing with ETFs, I would prefer to focus on at-the-money calls. A couple of reasons: 1) at-the-money options are priced most efficiently usually with the tightest bid asked spread, and 2) at-the-money options tend to offer the best balance between cash flow, downside protection and upside limits.

The high cost of trading options was another issue raised by both Vlad and Joseph Talone. Although, I am not sure that the cost of trading options is that much different than is the costs associated with trading the underlying security. It really comes down to how you are defining costs.

For example, suppose you are buying 10 XYZ 50 calls at $5.00. The total purchase price is $5,000, and for simplicity, let’s assume you pay $200 in commissions. On the surface, that looks expensive, considering transaction costs equal 4% of the total purchase price.

However, compare that to buying the equivalent position in the underlying security. If you were to buy 1,000 XYZ shares (i.e. 10 calls = 1000 shares) at $50, your total outlay for the stock position would be $50,000. That would also likely cost $200 in commissions. The $200 commission equals only 0.40% of the total cost, but in both instances, the per share cost is the same (i.e. 4 cents per underlying share).