Buzz and Banter
Kevin is all over the technicals on gold, so I will leave that commentary in his capable hands. We have a very large position in gold volatility, the impetus being volatility in the currency market. As debt builds around the world, every country has a desire to keep their currency cheap. We consider gold the anti-(fiat) currency (or more accurately, the only real currency).
The XAU index is composed of several gold mining companies, the second largest component being Barrick Gold(ABX:NYSE). American Barricks is a hedger: they sell forward much of their production to guard against a drop in the price of gold. The largest gold mining company in the world, Newmont Mining (NEM:NYSE), does not hedge most of its production.
If gold can break above 400 meaningfully you would expect NEM to outperform ABX for this reason. If gold does little from here, you would expect NEM to still outperform somewhat. If gold drops significantly from here, you would expect ABX to outperform (not go down as much) NEM.
You can design a trade to isolate the situation of a breakout in gold. You can buy one NEM January (2004) call for $2.45 and sell two ABX January 22.5 calls at $1.00. Both options are slightly out of the money. The design of this trade guards against the scenario of a large drop in the price of gold. If this occured and you only bought the NEM calls, you would lose your entire premium. If both stocks go down you will lose only the very small amount of the difference between the premiums of the calls. If gold breaks out on the upside, NEM should outperform ABX.
The margin on this trade is 50% of the strike of ABX less the premium and the out of the money amount. You must pay in full for the premium of the NEM options.
This trade effectively isolates the risk of being short ABX and long NEM if both stocks appreciate. And please understand that this is NOT a recommendation to act--I am simply trying to offer a real-time trading example.
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