Karim Rahemtulla, the Oxford Club’s Options Specialist, points out that, using options, investors are able to buy stocks in major gold companies for pennies on the dollar. Here’s how it works.
For the sake of this illustration, we’ll start with a large gold mining company – call it Company Z. Company Z is a low-cost producer with very little of its production hedged. Its shares sell for $17. Z’s price tracks the price of gold much like Newmont, Placer Dome or Anglogold, all three of which are up about the same percentage in the past 52 weeks. You could invest $17,000 in 1,000 shares of Z, hoping your shares will reach $34 over the next two years, so that you’ll make 100% if gold moves over $500. In case you are wrong, you set a stop-loss of 20% or about $3,400. So, you either make $17,000 or lose $3,400 on Z in the next twenty-four months, or end up somewhere in between. Meanwhile, you have $17,000 tied up.
Making $17,000 is good. Losing $3,400 isn’t. Instead of taking this risk, using an options strategy, you would go through each stock that you own and check for an Options chain. Look for a particular type of option called a LEAP. LEAPs are Long-term Equity Anticipation Products. These are options that expire in one, two or three years. If your stock does not have a LEAP attached, skip it. For each stock that you own that has a LEAP attached, you sell the stock and buy the LEAP within 10% to 15% of share price. This means that if you own Z and the shares are currently trading at $17, you might buy the Z LEAP option with a $20 strike price. The Strike Price is the price at which you are entitled to buy Z through the option, if you wish. Rather than actually take possession of the shares, most investors just sell their options when the times come to take a profit.
The Z $20 LEAP call option that will expire in 2 years will cost you about $2,500, for the right to own 1,000 shares. That is 15% of what you would have otherwise invested in a straight purchase of 1,000 Z shares, and about 26% less that what you are willing to risk losing on the position. If gold does reach your $500 target price in two years, you will make 500% on your money, as opposed to the 100% if you own the shares.
The math works like this: if Company Z’s shares do rise to $35.00, your LEAP will be worth about $15.00. You paid $2.50, so you made $12.50 on your $2.50 investment. Of course if the stock goes even higher, then you will make even more. And it gets better.
Let’s assume you have a million dollar portfolio spread across 20 blue chip stocks. Your upside target for 2004 is 20%. You are strict about not losing too much money, so you institute a 20% stop-loss. So, you are willing to lose $200,000 to make $200,000. Now let’s look at the LEAP way of doing things. For $70,000 or less, you could take a two-year position mirroring your million dollar portfolio. The remaining $930,000 can sit in a two-year protected investment earning 2% — that would make you about $40,000. So your real risk is $30,000 net. Let’s assume the market takes your shares up 20% on average. If you had bought the shares outright, you would make $200,000 on your original $1 million portfolio (with $200K at risk).
Your LEAP portfolio, however, would be worth on average about $200,000 based on the same 20% move. So, with the LEAP portfolio you have netted $150,000 on your $50,000 (net investment) or about 200% in gains. On a wholly owned $1 million portfolio you would have made the same $200,000 but, with a 20% stop loss, at a risk of losing $200,000. With the LEAPs, your risk is limited to $30,000, with an extra year left on them.
Of course, if the market goes nowhere, then your LEAPs will expire worthless. While there are strategies you can use to mitigate options risks, when it comes to LEAPs it is best to assume that you are risking 100% of the money you invest. But the basic assumption here is that you are investing to make money in the market, not to tread water. If you knew that the market was going nowhere, you wouldn’t invest. Nor should you risk $1 million, hoping you can get out in time to lose a mere $200,000, when you could limit it to $30,000 in the event of a market reversal.
There is one other negative, namely that LEAPs are not available on most of the smaller exploration companies that can offer such explosive upside. Instead, you are limited to the fairly significant gold producers.