Options Are a Gold Bull’s Better Play Than Owning High Beta Miners – Here’s Why (2K Views)

So says Sam Kirtley (www.skoptionstrading.com)  in edited excerpts from his original article*.

Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!) and www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) has further edited ([ ]), abridged (…) and reformatted (some sub-titles and bold/italics emphases) the article below for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

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Kirtley goes on to say, in part:

Understanding Beta Better

The financial tool that measures the relationship between the movement of  different assets is called “Beta” which is a measure of risk and compares the historical return of asset X with the return on the relevant market index over the same time period.

• A positive Beta indicates the asset’s returns generally move in the same direction as the whole market
• A negative Beta indicates the opposite, when the market is rising the asset is generally falling and vice versa.
• A Beta of zero indicates [that] the asset’s price moves independently of the market.
• A Beta higher than one indicates the relevant asset moves in the same direction as the market, but with greater magnitude. In times of market growth, an asset with a Beta >1 will return more than the market, but conversely, in downturns, the asset will suffer greater losses than the market’s.

By definition, the Beta of the market is one – that is, the returns on the market are exactly correlated with the returns on the market in direction and magnitude. Generally speaking the higher the Beta, the riskier the asset, and the higher it’s exposure to movements in the market.

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For example, Ford Motor Company’s current Beta given by Yahoo Finance is 2.28. If the S&P 500 were to rise by 10% over the next ear, one would expect to see an (approximate) 22.8% rise in Ford’s stock price; conversely a 10% fall in the S&P would likely see a 22.8% fall in Ford’s stock. 2.28 is a relatively high Beta, implying Ford is a relatively risky stock. In contrast, Exxon Mobil’s current Beta is 0.53, implying a lower risk investment, providing gains (or losses) of less magnitude than the market’s. If one is bullish on the equity market, higher Beta stocks such as Ford allow for a higher return over stocks such as Exxon. High Beta stocks are a bull’s best friend.

Note: Beta, as with all financial statistics and measures, is based entirely on past information. It is a tool, not a crystal ball and should be treated with due scepticism applied to all financial statistics.

Intuitively, Beta is dependant on the nature of the industry concerned. Exxon’s low Beta is likely due to the inelasticity of demand for fossil fuels, and as such their income stream is relatively constant irrespective of the state of the market/economy as firms and consumers always need fossil fuels. Conversely, Ford’s profits are reliant on sales of motor vehicles which are far less frequent in a downturn; hence Ford suffers greater than Exxon when market conditions worsen. The converse is also true. When the economy is growing, vehicle sales pick up at a far greater rate than the demand for fossil fuels and Ford is a greater beneficiary of a bull market than Exxon.

Applying Beta to Gold Stocks vs. Gold

The same reasoning above applies to gold stocks versus gold. We can measure the returns of gold stocks versus the returns of physical gold with the Beta statistic. Instead of measuring mining stocks against the S&P 500, our “market benchmark” is now the price of gold. Some straightforward analysis reveals the following:

The data above shows gold stocks offering increased exposure to the price of gold, as the majority of the Betas for these mining stocks/indexes are > 1. Again, if we expected to see a 10% rise in gold in the next year, we would expect to see an approximate 10.8% rise in the HUI index (using the 1 year Beta statistic).

At this point one may be thinking, if that is the case, why not trade mining stocks for increased exposure if one is bullish on gold, as the return will exceed that on gold itself. The graph shown below should shed some light on why we believe this is a flawed strategy.

Gold Stock Correlation With Gold is Inconsistent

Although, gold and mining stocks usually move together, as is the broad trend above, there are periods where this is simply not the case. Mid-April through to September 2011 is a period where a gold bull invested in mining stocks would have been thoroughly underwhelmed with the performance of his stock, objectively and even more so relative to gold over the same period. His view on gold was totally correct, but his decision to invest in mining stocks (Betas of > 1) to increase his exposure to the predicted rise in gold was punished. This theoretical trader would have rewarded his correct outlook handsomely by using leveraged instruments that have a direct relationship with gold, rather than mining stocks which do not. [Why is that the case? Because,] as explained in a previous article, mining stocks are susceptible to various external factors that are difficult to anticipate and require extensive analysis over and above that of gold.

Whilst it is true, more often than not, that mining stocks move in the same direction as gold, periods where this relationship does not hold are one of the reasons we currently have no interest in trading or investing in mining stocks. Why form a bullish view on gold and buy mining stocks based on this view, only to see gold rise and mining stocks fall?…

Conclusion

Using gold stocks to increase exposure to gold is a terrible strategy in our view…

Derivatives, ETFs on margin, leveraged ETNs, and leveraged ETNs on margin all serve the same purpose as a trader using mining stocks to increase exposure to the gold price, the difference being these instruments have a direct relationship with gold.

Our preferred strategy is an options trading portfolio that is traded to optimize and maximize potential profits, using options that are directed based on the price of gold with no other factors influencing their performance. The gold bull using these instruments will always be rewarded concordant to his view, when gold prices rise. The gold bull using mining stocks to gain exposure to gold will usually be rewarded with a rise in gold. It is this dubiety we aim to avoid.

*http://www.skoptionstrading.com/updates/2011/11/15/the-gold-beta-of-mining-stocks-and-why-we-continue-to-avoid.html

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