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Synthetic HUI Options

Adam Hamilton
July 16, 2004

Speculators have always loved the incredible power and versatility of options, contracts which grant the buyer the right but not the obligation to buy or sell a security at a specific price within a finite period of time in the future.

The strategic use of options contracts enables speculators to leverage their exposure by buying additional risk or reduce their exposure by selling their existing risk to other willing buyers. Options render speculative markets far more efficient by facilitating the transfer of risk from the risk adverse to those most willing and able to accept it.

The most well-developed options market on the planet today is based on the QQQ exchange-traded fund, the famous NASDAQ 100 tracking stock. Vast volumes of QQQ options trade each day, with almost unfathomable amounts of risk being transferred from hedgers like mutual funds to speculators like hedge funds. The instant liquidity provided by the QQQs and their options has made the tech sector the most trader-friendly market in existence.

Since this tech sector remains so popular even after the trillions of dollars lost when its bubble burst, it continues to dominate financial-market innovation. Other less popular sectors including gold stocks have lagged behind significantly. This presents a challenge to speculators trading in these secondary sectors that have not yet won popular acceptance and lack the extraordinary liquidity of the tech sector.

Although still overlooked by the general populace, gold-stock performance has blown the doors off technology in recent years. From March 2003 to January 2004, the ever-loved NASDAQ Composite ran up 69%, certainly a very impressive cyclical-bull run. Yet, when compared to the HUI unhedged gold-stock index, the flagship index of the precious-metals sector, the NASDAQ's performance looks downright pathetic.

Over roughly the same time period, from March 2003 to December 2003, the HUI rocketed up by 125% in a spectacular upleg almost doubling the NASDAQ's winnings. Yet few realize this since the gold-stock bull remains largely under the radar of major financial-news outlets like CNBC. From its stealthy launch in November 2000, the HUI's bull-to-date gains are weighing in at a jaw-dropping 614%! Talk about a bull market, wow!

Naturally an accelerating bull of the magnitude of the HUI's is a paradise for speculators. We have already been blessed with enormous winnings so far in this bull and odds are the best is yet to come. In my case personally, and many of our newsletter subscribers, most of the profits won so far have been in trading actual elite unhedged gold stocks including many of the HUI index components. Carefully timing these individual stocks will remain the foundational core of our bull-market strategy going forward.

Yet, it is nice to augment a speculative gold-stock portfolio with even higher-risk higher-leverage plays. The four major HUI uplegs to date have averaged 111% gains each, not bad at all. Speculators, while probably quite content with the lion's share of their portfolios reaping these kinds of gains, are always looking for higher-octane trades for the smaller high-risk portion of their capital. Why not take your most speculative pool of capital and shoot for doubling or quadrupling the HUI's upleg gains?

Traditionally this has been done by speculating in junior gold stocks, small unproven ventures that are not actually mining gold yet. The fascinating realm of juniors is extraordinarily risky though. These juniors have no profits and hemorrhage cash faster than a sieve, so they rely on the capital markets for financing and a lot of luck to attempt to find bonanza-type properties to mine or sell. Many remind me of dot-coms of the late 1990s, blue-sky ventures built on nothing but dreams.

If you are fortunate enough to pick a junior that strikes it big, 100x+ returns are possible. Unfortunately the vast majority of unproven junior miners eventually fail and their shareholders lose their capital. Unless you are a mining geologist with inside knowledge of particular companies' exploration projects, junior miners are essentially a crapshoot. In addition, juniors are almost always actively gamed by unscrupulous promoters and pump-and-dump schemes are rampant in this hyper-risky arena.

An alternative strategy for leveraging HUI uplegs, and even corrections, is using options. HUI options are nowhere near as risky as junior-mining speculation. To use HUI options to win big all you have to do is roughly time major uplegs in gold stocks and then buy call options as a new upleg gets underway. This is a pure macro analytical exercise that is far easier than trying to guess which of 25 Canadian exploration companies is most likely to strike it big in the next six months.

So let's say you expect the HUI to trade above 280 by Thanksgiving, up from 200 today. You could buy a HUI December 220 call option for $15 or so. If the HUI does indeed hit 280 before your December expiration, your $15 option will be worth $60. A modest 40% HUI upleg would be leveraged up into an impressive 300% gain via HUI options. Naturally HUI puts could also be used to leverage the inevitable corrections following these uplegs. Sounds easy, right?

In theory it is, but in reality it is not because the HUI options market is a steaming pile of trading manure. Unlike the hyper-liquid QQQ market, today's HUI options market is a joke. The custodian of the HUI Gold BUGS (Basket of Unhedged Gold Stocks) Index, the American Stock Exchange, has failed miserably in running the options market for the HUI. HUI options volume is virtually nonexistent today due to the AMEX dropping the ball on two major issues.

First, the AMEX decided to make the HUI options follow the European expiration model as opposed to the far superior American model. European options are only exercisable on one single day, expiration day. American options may be exercised at any time between purchase and expiration, providing far more flexibility. This decision provides a huge psychological disincentive to HUI options trading.

Because speculators willingly accept big risks, they do not want any artificial limitations on their positions. Even though European options can be traded anytime, the restrictions on exercise tend to spook speculators and lower the perceived value of the options contracts. Speculators accustomed to trafficking in American-style options generally want nothing to do with restricted European options regardless of if they actually plan to exercise or not.

Second, since there is no HUI exchange-traded fund like the QQQs, the HUI options are not tradable within a normal options-enabled stock-trading account. This greatly limits their popular appeal since most gold-stock speculators, the primary market for the HUI, are not interested in dealing with all the hassles of opening and maintaining a separate futures-options account. The QQQ options have become so popular partially because they can be traded within a normal options-enabled stock account, with no futures broker or infrastructure necessary.

With unnecessary expiration restrictions and no availability through standard stock-trading channels, the existing HUI options are about as popular as Michael Moore at the White House. And if you examine a December options chain you can really tell. As I am writing this essay, the biggest open interest in December in any HUI options is 130 contracts, virtually zero. Just one of the dozens of December QQQ options, however, has an open interest of 75,201 contracts alone!

While actual HUI options in their present incarnation have sadly proven to be a dismal failure even during the greatest gold-stock bull in decades, I have long been pondering the concept of synthetic HUI options. In this context a synthetic option means another financial-market instrument that closely mirrors the way HUI options would behave if they were modeled after the extremely successful QQQ options market.

What if there was an existing option that was American style with unrestricted rights to exercise, that could be easily traded in any options-enabled stock account, that is well-developed and very liquid, and that very closely tracks the HUI? Amazingly enough, there is! Rather than grumbling at the AMEX for totally botching real HUI options, we can trade synthetic HUI options almost as good as the way the HUI options ought to be.

Like the NASDAQ 100, the HUI action is derived from that of its underlying component companies. While the NASDAQ 100 has 100 member companies, the HUI has 16. The gold-stock universe is much smaller than the tech-stock universe which makes it far more responsive to new speculative-capital inflows. $10b chasing tech stocks is trivial, but the same $10b buying gold stocks is a big deal.

In the NASDAQ 100, the single largest component by market capitalization is the mighty Microsoft. MSFT is directly responsible for about 8% of the movement of the NASDAQ 100 and its QQQ tracking stock. The top 10 NASDAQ 100 companies account for 40% of the index's weight and movement, effectively dominating its trading behavior.

In the far more concentrated HUI, the top 3 component companies alone account for almost 40% of the index's weight and movement. American giant Newmont Mining takes the pole position, commanding over 15% or almost 1/6th of the HUI's entire weight. It is followed by South Africa's Gold Fields at 14% and Freeport McMoran Copper & Gold at just over 10%. None of the other 13 components even exceeds 6%, so these three companies truly dominate the HUI.

Thus Newmont, Gold Fields, and Freeport are like the Microsoft, Intel, and Cisco of the gold-stock world, influencing their sector more than all other stocks combined at times. Of these three companies, only one precisely tracks the HUI however. This company, Newmont, already has a thriving and liquid options market which acts just like synthetic HUI options. Before we delve into this concept though, let's eliminate Gold Fields and Freeport McMoran as exceptional HUI proxies.

Gold Fields is a great South African company I have owned during past uplegs and been blessed with big wins on, but it does not track the HUI precisely for a couple major reasons. First, in recent years the Marxist government of South Africa has grown bolder in its anti-capital rhetoric. It has passed laws designed to confiscate portions of South African gold mines from their lawful owners.

And even if you can overlook the scourge of Marxism, stealing from the industrious to subsidize the lazy, South African mines are hurting due to soaring costs in their local currency the rand. As the US dollar bear continues, naturally the rand is rising. Along with the rand, all of the costs of mining for South African mines go up as well. Since this current gold bull is primarily a dollar-weakness phenomenon so far, the gold price in foreign-currency terms has been far weaker hurting non-dollar-centric mining operations. Thus the South African miners are not tracking the HUI closely these days.

Freeport McMoran is another very impressive company, but it is a primary copper miner. In 2003 54% of its revenue was from copper sales. It did mine 2.5m ounces of gold and 4.1m ounces of silver, but for Freeport these are largely byproducts from its massive copper mining operations. While Freeport is a fine company, many HUI purists, including I, believe that it should not be included in the HUI since it is not a primary gold miner. Needless to say, Freeport's trading action is far more sensitive to copper prices than gold prices.

With two of the top three HUI companies eliminated as synthetic-HUI-options candidates since they don't track the index close enough, that leaves Newmont Mining. Denver-based Newmont is the largest unhedged gold miner on the planet, producing 7.4m ounces of gold in 2003. In addition to dominating the HUI, it is also the only pure gold miner included in the flagship S&P 500 stock index. This visibility outside of the gold world greatly improves its liquidity and helps ensure it has a thriving options market.

Due to its market dominance and S&P 500 exposure, Newmont's options chains sport the highest trading volume in the gold-stock world. While the largest December open interest in any individual HUI contract was only 130 contracts, just one of NEM's December options already has an open interest of 5,247 contracts, or 40x as much. And regardless of which expiration month you investigate, total NEM options open interest always runs in the thousands or even tens of thousands.

Now a thriving options market alone does not necessarily make Newmont an ideal synthetic HUI option foundation. Options pricing is primarily based off of volatility, so we have to compare the underlying volatility of NEM to that of the HUI. In addition, if we are going to use NEM as an options proxy for the HUI, we have to be darned comfortable that it tracks the HUI very closely.

Our first chart this week addresses these crucial issues. It is a graph of Newmont superimposed over the HUI. Running from early 2003, this time frame provides an excellent baseline comparison since it encompasses the latest full upleg and the latest full correction in the gold-stock world. Gray fulcrums denote these major short-term trend changes dividing upleg from correction.

We statistically analyzed each major upleg and correction and noted these numbers on the chart. Blue numbers apply to the HUI and red numbers to NEM. The first number is the gain or loss realized during each individual upleg or correction. Right under this is the average absolute interday volatility attained during each major swing. Finally, the square of the correlation coefficient between the HUI and NEM is noted for each upleg or correction to get a hard mathematical correlation.

In Newmont's case, additional percentages within parentheses are included after these base numbers. These illustrate just how closely Newmont followed the HUI. For example, if the HUI had average volatility of 1.00% and NEM had average volatility of 0.75%, then NEM's volatility would be running at 75% of the HUI's with this number recorded in parentheses.

As this graph clearly illustrates, NEM's trading so closely follows that of the HUI that it is just uncanny.

Before we delve into the underlying math for hard comparability purposes, please sit back and drink in this chart visually. The parallels between HUI and NEM trading are really extraordinary. As a matter of fact, if this graph wasn't labeled I think we would all be hard-pressed to tell which series was the HUI and which was NEM. Without the axes it would be really easy to pass off the NEM graph as that of the HUI and practically no one could tell the difference. The strict degree to which NEM visually mirrors the HUI is remarkable.

But options trading is a statistically-intense numbers game. A visual correlation implies an actual mathematical correlation, but the precise degree of conformity is not known with certainty until some rudimentary statistical analysis is performed. We will concentrate on three areas for this analysis, the magnitude of major moves, the actual interday volatility, and the r-square correlation value of these two data series.

In terms of magnitude, NEM options will only make good HUI synthetics if NEM moves in a similar percentage range as the HUI. In last year's major upleg, the HUI ran up 125%. NEM's own upleg followed closely behind weighing in at 104% before it gave up its own ghost in early December. 104% divided by 125% (and rounded) indicates that NEM had 84% of the range of the HUI in the 2003 upleg. This is great news because in order for NEM options to mimic what HUI options ought to be it has to have similar major swings within its own secular bull.

In this chart one full upleg, one full correction, and the early months of the next major upleg are shown. During these three episodes the full range of NEM ran 84%, 85%, and 102% of that of the HUI. If we average these numbers we get a 90% result. This reveals that the Newmont stock underlying the NEM options is swinging through 90% of the range of the actual major HUI uplegs and corrections. 90% of the HUI's range magnitude is plenty high and definitely passes muster for synthetic HUI options!

After the range of the major swings, volatility is also a very important factor to consider. Options pricing is primarily based on volatility. If the HUI and NEM don't have comparable volatility profiles, then the pricing of NEM options will be out of whack with what true HUI options ought to be and it will be far more difficult to profitably trade the major HUI swings via NEM options. Thankfully, NEM volatility matches the HUI's very well.

In the 2003 upleg, the HUI's average absolute interday volatility ran 1.66% compared to 1.53% for NEM. Thus, NEM had 92% of the daily volatility of the HUI. If we average all three of these major swings, NEM's volatility ran at 87% of the HUI's on average. With NEM commanding a volatility profile roughly 7/8th as volatile as the HUI's itself, the pricing on NEM options should be very comparable to what true HUI options would be. This is also great news and very encouraging.

Finally, we need to confirm our visual comparison via statistical correlation. These numbers were particularly fascinating to me. During the massive 2003 HUI upleg, NEM had such a high correlation with the HUI that its correlation coefficient squared, the all-important r-square value, was 97.3%! Since a value of 100% means that the HUI and NEM always move together all the time and the behavior in one fully explains that of the other in mathematical terms, 97% is extremely high.

If we average the r-square values across all of these major swings, we get a still impressive 90% result. Thus, since early 2003 90% of the movement in NEM was directly attributable and explainable by the movement in the HUI, and vice versa. In statistical terms the HUI and NEM have been trading as if they were one. The actual correlation numbers empirically verify our visual sense that these two data series are amazingly alike. Interestingly as well, the longer the period of time analyzed the higher the r-square, as the three regions of this chart indicate.

In light of this hard statistical evidence, it is exciting to realize that NEM options are essentially synthetic HUI options! Since NEM sports 90% of the HUI's major-swing range, 87% of its absolute volatility profile, and a 90% r-square value, trading NEM options provides 90% of the behavior and impact of trading the HUI options directly. And, unlike the pathetic HUI options, NEM options are highly liquid, exercisable anytime, and easily tradable via any garden-variety options-enabled stock account!

Rejoice fellow gold-stock speculators, for synthetic HUI options with all the best attributes of the QQQs do exist today! They are just camouflaged under the stock symbol NEM.

And naturally with such a tight mathematical relationship the HUI and NEM are also technical twins over the short term as well. Here we zoom in to just the latest correction and interim-bottoming phase of this gold-stock bull market.

While bull markets are driven by long-term fundamentals, actual real-time trading decisions are driven by technicals. It is fascinating to realize that the short-term trend channels of the HUI and NEM have identical slopes! The blue and red lines above representing the most recent tactical HUI and NEM trends are all parallel. Since the HUI and NEM are technical twins it makes it fairly easy to make timing decisions on trading NEM options as HUI synthetics.

For example, at Point 1 above in early December, the HUI was overbought and due for a correction. A technically-oriented speculator could have gleaned this high probability of a pullback by examining the HUI chart alone. Once our speculator was convinced that a healthy bull-market correction was probably looming, all he needed to do to trade his hunch was to pull up a NEM chart.

At the time NEM topped near $50, so our speculator would consider buying out-of-the-money NEM puts as HUI synthetics. He might have bought $45 puts on NEM that expired six months out for $5 a contract or so. And since he had studied the history of this bull market he knew that the HUI generally corrects by a third or so after each major upleg, so he even had a NEM/HUI target in mind.

If the HUI was probably due to correct by a third, then NEM's pullback should run about 90% of this or 30%. A 30% pullback from a NEM $50 interim high yielded a target NEM price of $35. So our speculator knew that if the HUI corrected, NEM would probably head down towards $35 which would make his $45 puts worth at least $10. Thus, even if he paid $5 for these puts, he could have doubled his speculative capital even during a HUI correction! And all of this trading could be executed within a matter of seconds from his usual options-enabled stock account.

And once the correction looked like it had essentially run its course and a new HUI upleg was imminent, our speculator could sell his profitable puts and buy calls. Near Point 3 above, the speculator could have purchased NEM $40 calls expiring at least six months into the future. The average HUI upleg in this bull to date has run up about 111%, and 90% of this yields a NEM upleg target of 100%. Since NEM bottomed near $35 in early May, a 100% gain in this stock suggests a potential $70 NEM target level.

If this indeed comes to pass our NEM $40 HUI synthetic calls would be worth $30 each if this upleg reaches its expected maturity before expiration. In recent months we have been recommending and buying these calls around $3 to $4. The potential leverage obtainable using NEM options as HUI synthetics to ride the major uplegs and corrections is just breathtaking!

See the beauty in this? A gold-stock speculator like you or I analyzes the HUI itself and games its major uplegs and corrections. Leading into the uplegs we buy elite unhedged gold stocks but we can also add leveraged rocket fuel to our speculative portfolio by buying synthetic HUI calls, trading today as NEM calls. Our portfolio gains are leveraged to the upside dramatically with the calls and we didn't even have to take the hyper-risky jump into the turbulent sea of unproven juniors.

If you are well-capitalized and can afford the extreme all-or-nothing risks of options trading, we have already been implementing our synthetic HUI options strategy via carefully deployed NEM options. The actual trades have been and will continue to be detailed for our newsletter subscribers as they happen. We are actively acquiring synthetic HUI options at apparently opportune moments in anticipation of the next massive gold-stock upleg I discussed last week.

These synthetic HUI trades are detailed as appropriate in real-time in our anytime Zeal Speculator alert/update service for speculators as well as once a month in our popular monthly Zeal Intelligence newsletter. I have been layering in these trades since April for our subscribers but hadn't yet had the chance to explain this synthetic HUI options strategy in detail, hence this essay.

Naturally we will continue trading and making new recommendations as appropriate in future editions of both of our newsletters for our subscribers. Our latest ZI synthetic HUI call was up 47% as of Wednesday, two weeks after it was first recommended. The profits attainable in this gold-stock bull are certainly large enough to make even the most jaded dot-com refugee drool!

The bottom line is even though the true HUI options market today is a joke, synthetic HUI options do exist. The elite unhedged miner Newmont moves as one with the HUI, with similar major swings and underlying volatility profiles.

Speculators wishing to leverage major HUI uplegs and corrections with options can substitute highly-liquid NEM options for the nonexistent HUI equivalent of the QQQs with a 90%ish effectiveness.

July 16, 2004
Adam Hamilton, CPA
email: zelotes@zealllc.com

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