The Perfect Option
by James J Puplava CFP, President & CEO, PFS Group. May 24, 2002
Option Basics
We all have options in life. Minimally, there's a Plan A or a Plan B to any situation. Options involve making a choice. It is your option to do something versus not to do something. When you purchase goods or services, you can add extra options for a price. For example, when you buy a new car or home, you are usually offered the basic sticker price and add more features for an additional charge.
Webster's dictionary gives several definitions for the word "option" -- a choosing, choice, the right of choosing, something that is or can be chosen, the right to buy, sell, or lease at a fixed price within a specified time. In the financial world, we are concerned with the last definition of the word option.
In the financial markets, an option is created through a financial contract known as a derivative. Originally, options were created by individual contracts between two parties that gave the option holder the right to buy or sell a particular commodity for a specified price and time. Every option is either a call option or a put option. Owners of a call option have the right to buy a particular good at a specified price; while the owner of a put option has the right to sell a particular good at a specified price and time.
In today's financial markets, you can buy options on almost every conceivable financial instrument and intangible asset in the market price. You can buy options on stocks, stock indexes, bonds, interest rates, commodities, and currencies. You can even own an option on the right to buy land, a residential home, an apartment, or a commercial building. The ownership of a call option gives its owner the right to call the underlying asset or good away from someone else for a specified price and for a specified time. Likewise, the owner of a put has the right to sell a particular good or asset to someone else by forcing that person to buy the underlying asset or good at a specified price during a specified period of time.
The right to buy or sell these assets is acquired through the purchase of a call or put option. Options are used for the purpose of buying or selling something. They are bought in the market place through traders by paying a premium to the seller of an option. In an option trade, there are two parties involved. For every owner of an option, there is a seller. The seller of an option is known as an option writer. When an option is sold, the option buyer pays the option seller (or writer) a premium. In exchange for the option premium, the option writer confers the rights to buy or sell something in exchange for the premium received. In an option trade, the buyer has all of the rights to buy or sell something at a specified price and for a specified time period. The option writer (or seller) has all of the obligations to either provide the specified asset or good or to buy the specified asset or good to fulfill the option contract obligation. In the case of a put option trade, the option writer is required to buy the underlying asset or good at the price specified in the contract -- regardless of market price or conditions.
Options (which are derivatives since they derive their underlying value from the basic asset or good upon which they are written) have risen in popularity over the last two decades. They are used in the financial markets for various reasons that range from risk management, speculation, trading efficiency, or for arbitrage. For example, a car dealer in the U.S. who buys foreign cars from Japan runs a currency risk. If the dollar falls against the yen, as it is doing now, the car dealer runs the risk that he will have to pay more dollars for the cars he orders from Japan. Why? Because the price of the dollar is falling against the Japanese yen. This means the cars he buys will become more expensive. To hedge this risk, he may buy a currency option on the yen that locks in the price of the yen versus the dollar. In this way, he has hedged his risk of a dollar devaluation against the yen and has controlled his exposure to this risk.
Option Trading for Efficiency & Speculation
Options can also be used for trading efficiency or to speculate in the marketplace. Suppose a trader believes that the price of Newmont Mining is going to go up to $42 a share. The trader could buy 100 shares of Newmont, which is currently selling at $31.30 a share for $3,130. Alternatively, he could choose instead to buy an option on Newmont. For example, he could buy a September $35 call option for 100 shares of Newmont Mining for $170. If the price of Newmont rose to $42 a share as he expected, his profit would be as follows for both trades.
| Cash Purchase of Newmont Mining | Option Purchase of Newmont Mining | |||
| Market Value at $42 | $4,200 | Market Value at $42 | $4,200 | |
| Cost | $3,130 | Underlying Purchase Value | $3,500 | |
| Profit | $1,070 | Gross Profit | $700 | |
| Profit as Percent | 34% | Cost of Option | $170 | |
| Profit | $530 | |||
| Profit as Percent | 312% | |||
As you can see, the trader could buy an option on Newmont Mining for less money, control the same amount of shares, and make more money through the leverage afforded by options. If the trader really wanted to speculate, he could invest the entire $3,130 and buy roughly 18 option contracts ($3,130/$170 = 18.41 contracts). In this case, he would control 1,800 shares of Newmont for the same amount of money. With speculation, his potential profit would be $9,540 instead of $1,070 if he invested the same amount of money ($3,130) in option contracts versus buying the stock outright.
This example has been simplified. I've left out the cost of commissions and have rounded the option contracts to 18 instead of 18.4. Option contracts are sold in round lots of 100 when purchasing stocks. However, as can be seen from this illustration, options can be used as a substitute for a position in the more fundamental asset or shares of Newmont Mining. If the entire amount of the purchase was used to buy options instead of the actual asset, those options could be used to leverage the trade. In the example above, the trader would be able to control 1,800 shares of Newmont with options versus 100 shares in the cash market.
The Time Factor
As attractive as options are for efficiency and leverage, they also have a few problems. Options have a time factor. In the example above, the option contract would expire in September. If the price of Newmont did not rise above the call price of $35, the option contract would expire as worthless. If the trader had bought the actual shares of Newmont Mining instead of the option contract, he would still own the shares of Newmont. When an investor or trader buys an option, it has a time value component. There are many more aspects involved in an option purchase that an investor and trader has to deal with that impact the price of an option contract. The world of option trading exposes investors to a lexicon of terms known as "The Greeks." I've covered these aspects in my article Rogue Wave - Rogue Trader, and Rogue Waves & Standard Deviations - Part 1, but they are worth repeating since they have relevance to the discussion of this article. The Greeks measure different dimensions of risk in an option position. The aim of a trader or speculator in an option contract is to manage the Greeks so that all risks are acceptable.
A Review of The Greeks
Essentially, the Greeks are techniques for hedging against the behavioral aspects of an option, future or a cash position. There is "Delta," which tries to capture gains from volatility by hedging a portion of the option value. The idea behind "Delta" is to make money on volatility. The more times you can delta-hedge an option, the more profit can be realized to help pay for the option investment.
Then there is "Gamma." Gamma is the second derivative of the option price, which deals with the sensitivity of the delta (rate of change of the delta) with respect to the cash price of the underlying asset. Because of the convexity of the option price curve, there is a greater opportunity for the change of the option price if the cash or spot price moves. In other words, greater convexity delivers more bang for the buck if you're long, and more pain if you are short.
Options become more expensive when volatility in the market is high, and less expensive when volatility is low. The sensitivity of an option's price to changes in its implied volatility, all other things being equal, is called the "Vega." There are other Greeks, such as "Rho," which deals with an option's sensitivity to changes in the domestic interest rate.
Time is a Deciding Factor
Essentially, the problem for all option investors is TIME. An option gives the option holder the right to buy or sell an asset for a specified time period. When the time runs out, the right to buy or sell a particular asset also runs out. Option investors are always playing against the element of time. When you are investing in options, you have to not only be right about the investment, you also have to be right about your timing. The price of an option will change with the passage of time. The tendency for an option price to change due to the passage of time is known as time decay. "Theta" measures the change in the option premium for a given change in the period of expiry (usually the passage of time). Theta describes how much time value is lost from day to day as a result of time decay. It is a precise measure of time decay.
In the example of our 90-day call option on Newmont Mining at inception, the option will hold 100% of its time value. However, each day it will lose 1/90 of its value. After day one, the option would have a time value of 89/90. During the early days of an option's maturity, it retains most of its time value. Time decay is almost constant during the first two thirds of the option's life and it increases during the final third of the options life as shown in the graph above. Therefore, option investors are always playing against time.
Investing in The Perfect Option - Junior Mining Stocks
In the gold and silver market, there is a way to invest in "the perfect option." This form of option still offers the leverage to the price of gold and silver that can be found in a regular option. However, it has the advantage of not having the same risk of time decay. The perfect option vehicle for investing in the gold and silver markets can be found by investing in the shares of junior mining companies. Junior mining companies outnumber senior mining companies by almost an 8:1 margin. Juniors are either an exploration company that explores for new deposits of gold or silver, or they may be a small mining company with only one or two mines in operation.
A Risky Business
Dry Holes and Financial Risk
Junior mining companies carry more risk than a senior mining company does because they are essentially exploring for new mine deposits. Like the oil business, they may end up with a dry hole. The money spent in trying to find a new deposit may fail. Therefore, their shares are subject to greater risk and volatility than senior mining companies. They also fluctuate and are more volatile against the rise or fall of the price of gold or silver. Because of the risk involved in finding new deposits of gold or silver, juniors mainly rely on equity financing through public offerings, private placements, or joint ventures with major mining companies. The risk for a junior is that the company will not find new deposits of gold or silver. Another risk is the possibility that when they do find deposits, they may not have the financial wherewithal to develop and maintain the property on which the gold or silver deposits were found.
Dirty Dealings
There is also the risk of fraud. Several years ago, the junior mining industry was tarnished by the Bre-X scandal. Bre-X Minerals went from becoming the world's largest gold deposit to the biggest gold swindle in mining history. Investors lost billions of dollars in the fraudulent stock scheme. The founders of Bre-X had gone to the jungles of Borneo and supposedly found the largest deposit in the world. Bre-X's Busang project in Indonesia turned out to be a hoax. Vivian Danielson and James Whyte write, "But Busang was more than an ordinary gold scam with a few zeros added, caused --- once again -- by gullibility and the lure of riches. It was an extraordinary popular delusion, adding yet another chapter to that great and awful book of human folly. Busang was a tragic triumph of ego and emotion over reason and science, as well as a triumph of timing, for it might well have remained a small, low-grade scam had it not been picked up and carried along by a Bay Street juggernaut with more cash than common sense and an army of investors predisposed to believe. ...Bre-X was a mammoth embarrassment, not only because it overshadowed the good work carried out by honest geologists and engineers, but because it had become one scam too many. Mining, particularly junior mining, is an industry that needs public support to survive. The trust over decades by honest mining men had been undermined too often by unscrupulous characters out to make a quick dollar through deceit and trickery." 1
For the exploration mining industry, the Bre-X scandal was the final straw. In its wake, new capital dried up for many junior exploration companies. Those companies that survived the scandal saw their stock prices crater, like the Internet bust, in the mining stock market crash that followed Bre-X. The combination of the scandal with lower prices for gold and silver and the technology boom of the late 90's saw capital dry up for the industry.
New Life For An Old Industry
Cleansing Breeds New Opportunity
However, conditions and opportunity within the industry have improved recently as part of a worldwide exploration expansion. This can be attributed to the lower price of gold and silver over the last two decades that has forced downsizing and consolidation within the mining industry. As a result of lower prices for gold and silver, most major mining companies have dramatically cut back their exploration budgets. In fact, many senior mining companies like Barrick have made more money through the sale of derivatives than they have actually mining gold and silver. The price of gold and silver has been so low that within most major mining companies only a few of their mines are profitable. Most mines are losing money or at best, breaking even. As a result, large mining companies have found it to be more economical to buy existing mining companies than mine for new gold or silver. Many companies have been forced to pick up old, inactive mines with marginal or slim reserves to bolster their inventory.
The Truth About Supply & Demand
It may surprise most investors to find out that demand for gold and silver has been greater than supply for over a decade. Additionally, both gold and silver have been running supply deficits for over a decade. Those supply deficits have been made up from scrap metal and the selling and leasing of gold and silver by central banks and bullion banks. These banks have had a hand in keeping the price of precious metals suppressed. Basic economics would argue for a higher price for gold and silver if demand exceeded supply for over a decade. This deficit has been made up by central banks' heavy selling of their gold reserves and by their leasing out gold to bullion banks. The bullion banks have, in turn, sold that gold into the markets. These transactions have helped to keep the supply deficit in equilibrium and thereby distorted the markets by keeping the price suppressed. This market control has forced the industry into consolidation, forced many companies into bankruptcy, and has made the exploration for new gold and silver reserves uneconomical. If this practice continues, it will eventually correct the supply and demand imbalance. By reducing the eventual supply, gold and silver prices will be forced to rise. Central bank gold reserves aren't endless and neither is the stockpile of silver.
This imbalance of supply and demand is just one of many reasons that the price of gold and silver is rising today. The supply and demand fundamentals argue for higher prices. You can't have companies operating or exploring for gold and silver at a loss forever. Nor will central banks or bullion banks sell off all of their entire reserves in order to keep prices suppressed. They will eventually have to answer to the citizens of their own country as to why their currencies are no longer backed by gold. There is a limit to the amount of faith people have in a paper currency when their central bank is constantly inflating the currency (Asian countries in 1997 and more recently Argentina).
Mining and Energy Share Similar Challenges
The immediate problem for the mining industry is similar to that seen in the energy industry. Both need to replace their reserves. Mining and energy companies are in the warehouse business. When you are in the commodity business, you produce commodities and then sell them. Picture a large warehouse building. In the back of the building is a door where new supplies are brought into the warehouse. The sale of the commodity goes out the front door. Unless the supply coming in through the back door is equal to the supply going out through the front door, your business is shrinking. That is why commodity businesses, like mining and energy, must constantly replace their reserves or else they will eventually go out of business. You can't remain in business, if you don't have products to sell.
The problem the mining industry (or for that manner, the energy industry) now faces is that it must replace its reserves at a time of low prices. Most mining companies have reduced their exploration budgets as mentioned previously. This means they must go out and buy those reserves if they are unwilling to spend money to explore and find them. That is why we have seen so many takeovers and mergers in the industry. Mining companies must constantly replace their reserves. The easiest way to do that in a bear market is to buy other companies. The only problem for the eventual supply and demand imbalance is that buying other companies doesn't increase worldwide supply. In other words, it's like taking from one pocket and putting it into another. Furthermore, finding new reserves takes time and money. It takes a minimum of three years from the time of discovery to building the new mine if everything goes well. The average production time is closer to six years.
There is also the problem of environmentalists who are trying to set up roadblocks and stop the exploration for all natural resources in the name of protecting the environment. For some strange reason, most people fail to make the connection between the industrial society we live in and the natural resources that make our economies prosperous. The lifeblood of western economies is energy and it takes raw materials to make something. We seem to want all of the benefits of a modern industrial society without using any of the raw materials that give us our prosperity.
One reason it takes so long to get a mine into production is because of all of the environmental red tape required to bring a mine into production. In the case of Glamis� Imperial Mine, it took over seven years to get permitted. The growth of radical environmentalism is one reason we are headed for future raw material shortages and energy blackouts that will become a normal part of everyday life. I will have more to say about this in a future edition of Powershift. If you really want to understand the truth, I highly recommend reading The Skeptical Environmentalist: Measuring the Real State of the World by Bjorn Lomborg to get the real story.
Replacing Reserves
Junior mining companies are the main source of future mine supply. Many successful companies are finding new gold and silver reserves. These companies are sitting on gold and silver reserves in the ground. These reserves are, in effect, "the perfect option� on a price rise in gold and silver. You can buy gold reserves in the ground for as little as $4 - 8 an ounce. In the case of silver, you can buy silver in the ground for as little as $0.10 - .15 an ounce. These reserves are essentially an option on the future price of gold and silver. They are an option because those reserves still remain in the ground. They must be refined and processed into the metal before they enter the marketplace as refined gold and silver.
Because the mining industry is rapidly running out of existing reserves and there is a long lag time between when a new deposit is found, developed, and brought into production, the large senior mining companies will be forced to buy existing reserves in the ground from the junior and mid-tiered mining companies. A new era of buyouts, mergers, and consolidation is about to begin. The companies that have prime reserves in the ground will become takeover candidates for the majors and the mid-tiered mining companies. We are starting to see this not only with senior mining companies but also with mid-tiered companies and with a few juniors. This year we have seen mergers and acquisitions with Pan American Silver + Corner Bay, Glamis Gold + Franciso, Brancote + Meridian Gold, and Dayton + Pacific Rim Mining.
With the price of gold and silver moving up from their lows of last year, the price of gold and silver mining companies have exploded. As shown in these graphs of the HUI and the XAU, the price of these indexes are up over 113% and 45.5% respectively over the last 52 weeks. They are up 117% and 58.6% year to date. As I wrote in Wednesday's Market Observation this phenomenon is occurring globally and not just in the U.S. stock markets. Gold mining shares are rising in the U.S., Canada, Australia, South Africa, Latin America, and in Europe. As a result of currency depreciation, the global bear market in equities, and the rise of political tensions, investors have been exiting the financial markets and heading into gold and to a lesser extent, silver. This repositioning is an event that is being repeated by investors in Asia (especially Japan), the Middle East, Latin America and now North America as well.
As of this writing, the price of gold has risen to a 2 1/2 year high, gaining for the seventh consecutive session. The rise is attributable to investors seeking an alternative to stocks, bonds, and other paper assets. The price of bullion has now risen 16% this year. Unlike past short-lived rallies driven by speculators, this recent rally shows no sign of abating. The supply and demand imbalance has begun the process of rectifying itself through the mechanism of the markets. If the price rises further, it could suddenly spike up as bullion banks that are heavily short the metal are forced to cover their short positions. This may ultimately lead to a crisis since gold is running a supply deficit that has been made up by heavy central bank selling. Heavily hedged mining companies may also be forced to unwind their hedges since they are now losing money as is the case with the biggest hedger of them all, Barrick Gold.
I've already addressed these supply issues in my Perfect Storm Series and in previous Storm Watch Updates. Suffice to say that in my opinion, gold and silver are just in the beginning stages of a new multi-year bull market.
The Leverage of The Perfect Option
The companies that are in line to benefit the most from the future price of gold and silver are the shares of junior mining companies that have choice reserves in the ground. These companies, like an option, are heavily leveraged to the movement in the price of gold and silver.
Here is an example. As shown in this graph, the shares of a particular mining stock rose exponentially in comparison to a small movement in the price of gold. The shares of this mining company rose 300% on a 20% movement in the price of gold over the last 52 weeks. Compare the chart of this stock to the charts of the HUI and XAU above. Like an option, the price movement of a junior provides the leverage that an option does when the price of the underlying asset rises.
As shown in the table of junior mining companies below, many of them have experienced price movements that range from lows of 100% to highs of 600%. Many major and mid-tiered companies have seen their stock prices double over the last 52 weeks.
| Junior Mining Stock Performance 05/23/01 - 05/23/02 | ||
| Company | Symbol | % Change in Price |
| Samex Mining Corp. | SMXMF | 633.333% |
| Chester Mining Co. | CHMN | 400.000% |
| Mena Resources Corp/ | MEARF | 387.500% |
| Royal Gold, Inc. | RGLD | 373.394% |
| Minefinders Corp. | MNEFF | 311.765% |
| Golden Star Resources, Ltd. | GSRSF | 192.308% |
| First Dynasty Mines, Ltd. | FDYMF | 175.000% |
| Apolo Gold Inc. | APLL | 166.667% |
| Gold Reserve Inc. | GLDR | 152.381% |
| Bullion Monarch Co. | BMRK | 150.000% |
| Silver Standard Resources | SSRI | 140.291% |
| Pan American Silver Corp. | PAAS | 125.852% |
| Golden Queen Mining Co. Ltd. | GQMNF | 109.375% |
| Golden Cycle Gold Corp. | GCGC | 100.200% |
| Camden Mines Ltd. | CNMN | 100.000% |
| Source: Bloomberg | ||
These explosive moves have been in the juniors for the reasons listed above. However, it must be reiterated that the shares of junior mining companies are more volatile than the shares of most mining companies. They also carry higher financial risk due to the risks associated with mineral exploration, lack of ability to raise exploration funds, environmental risks, and the general risk of fluctuating commodity prices. However, for those wishing to capitalize on what I believe is the new bull market in precious metals, they offer the highest potential reward commensurate with higher risk.
Caveat emptor
It must be disclosed that I personally hold, as do a select group of growth accounts managed by my firm, significant positions in some of the above-mentioned mining stocks. In the mining industry, I see the same problem that exists in the energy industry, which is the replacement of existing reserves. The senior and mid-tiered mining companies are going to have to replace their reserves regardless of the price of gold or silver or else they run the risk of going out of business. In the words of mining geologist, Keith Barron of Straight Talk on Mining, "There is virtually nothing in the pipeline. Nothing at all."
This situation is one reason that a handful of juniors look so appealing. There is always a caveat. Investing in juniors entails some degree of risk. You need to know what you are looking at investing in before you invest, find a trusted advisor who knows something about the industry, or invest in a mutual fund. I have found three valuable tools for evaluating a junior. The company must have [1] absolute integrity of management, [2] an experienced technical team, and [3] the management ability to expand shareholder value through exploration and expansion of the resource base, while minimizing share dilution and avoiding debt.
When you invest in a junior, you are investing in an exploration company that must constantly tap the capital markets for money since they have no revenue source. They are looking to find reserves. The best way to evaluate their success is to look at the resource valuation per share. It tells you how well management is at finding and adding reserves without diluting shareholder value. This is my prime yardstick for financial measurement.
Another advantage of purchasing junior mining stocks is that their market capitalization is relatively small in comparison to other stocks. This makes them "untouchable" for many large investment funds. There are restrictions on many large funds that prohibit them from owning stocks under $10 in price. This places many juniors out of reach for the big boys. This isn't a problem for smaller investors. They can buy juniors when their prices are low. Whereas the larger funds have to wait until their market caps increase or the share float increases in size so these companies become liquid and tradable. Usually by the time this happens, the company is taken over by a mid-tier or senior gold producer.
There are other important things you need to know before investing in juniors. Rather than go through each one of them, I've included an article written by an expert geologist with years of experience in the industry, Dr. Keith Barron. You can click to his article here or find it on our Precious Metals Resource Page. As you read and understand more about this industry, you will find as I have that well-positioned juniors are "The Perfect Option" to a rise in the price of gold and silver. If you also believe as I do that gold and silver are just now in the beginning stage of a new bull market, then shares of gold and silver mining companies are the best way to capitalize on any price movement of bullion. Why? Because of the leverage of junior mining companies to the price of gold and silver. For those who can afford the risk and are wiling to do their homework, the junior mining company has many attractions as an investment. It has no expiration date (as all options do) and it offers the same leverage as an option to the upward move in the price of the underlying asset. That is why I believe juniors are in fact "The Perfect Option." ~ JP
Endnotes
1 Danielson, Vivian and Whyte, James, "Bre-X: Gold Today Gone Tomorrow," The Northern Miner, p.9.
Reference: Barron, Dr. Keith, "Practical Advice on Picking Junior Golds", Straight Talk On Mining www.straighttalkonmining.com
Acknowledgement
Cover graphic by Adam Puplava
© 2002 James J Puplava CFP, Storm Watch Update Archive
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