What I Said Last Week, That’s What I Did

by JDH on November 2, 2013

Last week I asked the question: Agnico Eagle Mines Ltd. Blasts Higher – A Sign of the Future for Gold Stocks?  The answer, apparently, is “no”.

AEMNov1-2013

As documented last week, AEM.TO – Agnico-Eagle Mines Ltd. had a great a great day, advancing 18% in one day.  Alas, this week, as the chart shows (click to enlarge it), Agnico Eagle gave back a big chunk of that gain.  Before the big move AEM was trading just under $28, before spiking to $32 two Thursdays ago, and topping out over $33 on Monday of this week, before dropping back to close the week at just over $30.

What can we learn from this?

First, when a stock makes an almost 20% gain in 3 days it is generally not sustainable, so a pullback is inevitable (more on that topic in a moment).

Second, it is a bit early to call an end to the gold correction.  It’s unlikely we will be making new highs anytime soon.

So, taking my own advice, what did I do this week?

I covered.

On October 24, the day of the big move, I sold the AEM November 32 calls for $1.04 each.  (A call gives the purchaser the right to buy my shares at $32, anytime up to their expiration date, which is after the close of business on the third Friday of the month, which in November is November 15, less than two weeks away).  If AEM.TO is trading for less than $32 on that date the calls expire worthless, and I get to keep the premium (the $1.04).

As you can see, this is a “two-edged sword”.  I’m happy that the stock closes below $32 because I get to keep the premium, and I don’t lose my stocks.  However, I’m sad, because my stocks are trading below $32; I own stocks to go up, not down.

However, in a volatile market like we are in, I have made the following two assumptions:

  1. Long term, gold is going higher, so I want to own stocks, despite their ups and downs.
  2. Since I’m holding the stocks long term, and since I expect volatility, it makes sense to sell calls when they are high, to mitigate my losses when they drop.

If I was a perfect market timer I could sell the stocks when they are high, and buy them back when they drop, but I’m not that smart.  As you can see, I sold the calls on Thursday; I should have waited until the peak on the following Monday, but I can’t pick exact tops, so I took my best shot.

All of the gold stocks had a good run, so I did the same with all of my blue chips, selling covered calls as follows (all for the month of November):

As of today, the value of the calls have declined, on average, by 74%, so if the gold market stays where it is for the next two weeks they expire worthless, and I pocked the premium.  I will have mitigated my losses, by around $1 per share on my holdings.

Does this strategy make sense?

Ask me in a year or two.

You could easily argue that recovering $1 on a stock that has dropped by $3 is silly.  The correct answer was to sell the stock and save the $3.  However, if I can time it right and recover a $1 every month, that’s $12 over the course of a year, which on a stock like Agnico Eagle that trades around $30 is a huge gain, far better than holding the stock.

Of course I can’t do it every month, but my strategy is relatively simple:  If the stock is still in a down-trend, it’s unlikely it will be breaking to new highs, so selling covered calls isn’t much of a risk; I’m not giving up potential huge upside in the next few weeks.  If I sell after the stock has had a good run for a few days, the odds are in my favor.

That’s the key: I don’t sell calls after a stock has dropped for five days; that’s the exact wrong strategy.  If anything, I should be selling puts.  By playing the trends, I make the wasting premiums my friend.

By options is very difficult, because with each passing day their value erodes, due to the time value of money. Selling an eroding assets makes more sense, so that’s the plan.

If the gold market continues downwards I should have sold everything, but for now I want to have my cake and eat it to.

Thanks for reading; more next week.

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