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Strategies & Market Trends : Strictly: Drilling II -- Ignore unavailable to you. Want to Upgrade?

To: ItsAllCyclical who wrote (26989)	1/30/2003 8:12:02 AM
From: Frank Pembleton	Respond to of 36161

Gold stocks versus gold Profiting from an intermarket spread Richard Croft -- Financial Post Right now, gold bulls are feeling really good about things. Which means that most everyone else is feeling quite bad about things. That said, gold is on a tear. Not for any fundamental reason, but because investors are concerned about world affairs, and apparently as a defence mechanism, prefer to hold gold than US dollars or euros. December gold futures are up from US$315 to US$360 in the last month or so. At the same time, the gold and silver index (symbol XAU) is up from 62 to 74. On a relative basis, the XAU is outperforming -- a 19% gain versus a 14% gain -- which is interesting, because the XAU represents a basket of gold stocks rather than the metal itself. And many investors believe that over the last while, gold stocks have actually been lagging the performance of gold. The reality lies somewhere in between. For one thing, says Lawrence McMillan, president of www.optionsstrategist.com, the XAU's stronger numbers are illusory. "If we measure the moves in standard deviations, which is the proper way to measure such things, then we incorporate volatility -- the facet of performance that is often ignored." Looking at it from that perspective, the 20-day historical volatility of December gold futures is 15%, versus a 20-day historical volatility of 40% for the XAU. According to McMillan, given the volatility number, the XAU would be expected to advance further, percentage-wise, than the gold futures when both are trending in the same direction. When you incorporate volatility into the equation, "gold futures have risen about three standard deviations, while XAU is up only about 1.5." That explains the discrepancy and why there have been so many articles about how gold stocks are lagging. Usually, when option traders see something like this -- i.e. an extreme relationship between two entities -- there is an opportunity for an intermarket spread. To make this case, you would look at the long-term performance of the XAU divided by the price of December gold futures. For example, if we divide the recent value for the XAU (82) by the December gold futures at US$375, the ratio is 0.22. Over the last eight years, that ratio has ranged between 0.36 and 0.16. When the ratio is low (i.e. below 0.24) gold stocks have been under-performing. When the ratio is high -- above 30 -- gold stocks have been outperforming. McMillan suggests, since the ratio is low -- albeit not at the lowest point -- perhaps gold stocks are generally underpriced with respect to the price of gold. That said, there are structural reasons for the recent underperformance. "Many gold companies have had disappointing earnings, due to their penchant for selling their product -- either with futures or forwards -- at what turned out to be lower than market prices." Still, there may be an opportunity, if you believe the ratio will move higher, say to levels above 30, where it was four years ago. According to McMillan, one might look at setting up a hedged position with options that have a chance to profit if either (1) gold stocks begin to outperform gold futures, or (2) if both markets make a substantial move in either direction. The second way to make money evolves out of the fact that we are using options in the position, so one side has limited risk, while the other side can make large profits. The suggested position is to buy three XAU June 70 calls and buy two June Gold 380 puts for a total debit of US$9,600 or less. The June gold options expire on May 9. A one-point move for each contract is equal to US $100. According to McMillan, the 3-by-2 ratio takes into account the different prices and volatilities of the underlying instruments. In theory, the entire US$9,600 is at risk. However, for that to happen, the price of gold would have to rise while the price of gold stocks fell. That seems unlikely, since most of the time, gold stocks and the price of gold move in the same direction. Profits would be made if the ratio climbs to 28 or if the prices of both gold and gold stocks rise substantially or both decline substantially. croftfin@aol.com nationalpost.com{599C36D7-9E9A-4658-9CB7-D0A0B4FD0A9B}