Synthetic HUI Options 2
Aug 14, 2004
In last month's "Synthetic
HUI Options" I argued that today's formal HUI options
market is so woefully underdeveloped that superior substitutes
are necessary for precious-metals speculators interested in trading
The thesis I advanced advocated using options on the largest
individual component stocks of the HUI unhedged gold-stock index
as synthetic HUI options. Today's largest HUI component
stock, Newmont Mining, took the top honor of trading the most
like the HUI it dominates. I concluded that trading options on
NEM stock was effectively the same thing as trading HUI synthetics
with a 90%ish effectiveness.
My first essay only considered the precision with which NEM tracked
the HUI over the most recent gold-stock upleg and correction,
together running from March 2003 to May 2004. Interestingly,
however, the HUI in its fantastic young bull to date has already
witnessed no less than four major uplegs and four
major corrections. So, at best the original analysis only covered
about a quarter of our gold-stock bull to date.
To truly understand HUI synthetics, we really need to consider
this entire bull market and not just its most recent upleg and
correction. Over the life of any bull market different forces
drive it and different component companies assume the lead at
various times in pulling a sector index like the HUI higher.
After we examine the viability of HUI synthetic options over
this entire bull to date, we will have a much better idea on
how well this theory really worked in the past and whether or
not it ought to continue working in the future.
The three largest component companies of the HUI are currently
Newmont Mining (NEM), Gold Fields (GFI), and Freeport McMoran
Copper & Gold (FCX). NEM accounts for 16.1% of the index
by market capitalization, GFI 15.9%, and FCX 10.3%. Together
these three behemoths utterly dominate this small 15-company
index by collectively commanding 42.3% of its entire market share!
In my original essay I discussed each of these three elite gold
In addition to being the largest HUI component wielding the most
influence on the index, NEM already has a thriving and highly-liquid
options market. As a pure American gold play, NEM also avoids
the primary weaknesses of its next two largest competitors. NEM
is not adversely affected by the US dollar weakness to the extreme
degree of GFI which is based out of South Africa. NEM also does
not derive more than half of its revenue from non-gold operations
While NEM won the competition as the most HUI-like stock, I still
wanted to compare how all of these HUI Big Three companies performed
over this entire gold bull to date. The HUI, NEM, GFI, and FCX
are all graphed below. In order to make these data series perfectly
comparable, we indexed them setting their base values equal to
100 at their respective late 2000 secular bear lows. At 100 they
are equal to their lows, at 200 they have appreciated 100% from
their lows, at 300 they have tripled from those lows, etc.
These graphs are also divided up into sections denoting the four
major uplegs and the four major corrections that the HUI has
witnessed in its bull to date. Major uplegs are numbered, and
the percentage gain or loss of the HUI during each major short-term
trend is annotated on the graph. The numbers under the percentage
figures record the number of trading days that each individual
upleg or correction took to fully run its course.
Finally, since I still receive questions about hedging gold mines
versus non-hedging gold mines, we included the world's largest
hedger Barrick Gold (ABX) in this graph as well. ABX is not
included in the HUI because it does hedge, or lock in future
selling prices for its gold today. Since hedgers sell away their
upside profits to speculators, their performance lags that of
unhedged companies dramatically during a gold bull.
This indexed graph really highlights the massive and nearly catastrophic
costs of hedging to the shareholders of hedging companies during
major bull markets in gold. Owning a company that sells away
its upside during a gold bull is foolish at best and negligent
at worst. Professional fund managers owning large hedgers are
really shooting themselves in the feet and hurting their clients
by holding hedgers when gold prices are rising.
The bottom-feeding black ABX
line shows the great folly inherent in locking in future gold
prices during a bull market. At best Barrick has merely doubled
over the past several years compared to massive gains running
from 4x to 7x for the three major miners dominating the HUI.
While this essay is not about hedging,
this indexed gold-bull-to-date graph really drives home the enormous
opportunity costs borne by shareholders in hedging companies.
Back to the HUI synthetics, it is really intriguing how the big
three have shifted leadership positions like horses in a horse
race at various times in the HUI's bull market. In the first
major upleg, the 113% move off rock-bottom lows noted above,
it was actually FCX the copper company that dominated. It more
than doubled with a 152% gain by early 2001 while NEM and GFI
lagged behind at +86% and +107% respectively.
In the HUI's second major upleg, South African giant Gold Fields
blew everything else out of the water by skyrocketing above 6.5x
its secular bear lows of late 2000. While GFI used to be one
of my personal favorites and long-term recommendations, I quit
recommending SA golds in the summer of 2002. After realizing
158% gains in Gold Fields and 372% in the smaller Durban Roodepoort
Deep, in the July 2002 issue of our Zeal Intelligence newsletter
I sadly suspended SA recommendations on geopolitical concerns.
The South African ruling African
National Congress government, which is openly Marxist and
has long officially partnered with the South
African Communist Party in the Tripartite Alliance, is becoming
more and more aggressive and surly regarding capitalism. Two
years ago it announced that it would be forcing South African
mining operations to ensure that large percentages of ownership
are eventually transferred to black owners through "empowerment
targets", essentially racial quotas.
A leaked internal ANC government document in July 2002 suggested
that mines should be forced to surrender 30% of their assets
to black investors or face outright nationalization. This terrifying
document also said that 51%+ of new mining ventures should be
owned by blacks within a decade. Naturally this created a firestorm
of controversy internationally and the Marxists quickly backed
down publicly, but they are still pursuing these twisted agendas
advocating stealing from capitalists and giving to others as
bribes for votes.
Most capitalists start out poor as well and work long and hard
to build their fortunes, so these investors have no desire whatsoever
to see criminal governments like South Africa's steal from the
productive to subsidize the lazy. The ANC's increasingly belligerent
attitudes towards capitalists have done immense damage to the
once universally admired South African mining sector. GFI, South
Africa's flagship mining operation, has yet to fully recover
from the massive geopolitical damage done by the institutionalized
pro-black racism permeating the ruling ANC government.
In addition to the madness of Marxism and the always percolating
threat of confiscation of mines in South Africa today, the SA
mines have also been badly hurt by the ongoing US
dollar bear. As the dollar has slumped, the competing rand
has soared. The SA mines essentially sell their gold for dollars,
but pay their costs in rand. Thus their revenues are not rising
dramatically but their costs in local-currency terms are much
higher squeezing their profits.
Because of its sad misfortune of suffering under a Marxist government
along with the ongoing dollar/rand currency concerns, GFI is
not an ideal candidate for the HUI synthetics today. Its
performance during the second major HUI upleg was phenomenal,
but it has ground sideways to lower ever since. GFI remains a
fantastic company and I am personally looking forward to getting
back into SA mines once the ruling Marxist criminals of the ANC
are run out of the country and the US dollar bear runs its course.
Freeport McMoran's performance relative to the HUI has flowed
and ebbed as well. In the first and fourth major uplegs above
it dominated the other Big Three HUI stocks. Its most stunning
rally in 2003 was driven by a massive
rally in copper. Over half of FCX's revenue is derived from
copper mining operations, and much of its gold production is
a byproduct of extracting copper.
While FCX is certainly a great mining company, it trades far
more like a copper miner than a gold miner, as it should with
the majority of its sales from copper. If copper prices were
to halve in the next year but gold prices doubled, for example,
I am almost certain that FCX would fall and start acting as an
anchor on the HUI's performance. I am one of the HUI purists
that believe that a primary copper miner has no place in an index
designed to track the fortunes of unhedged primary gold and silver
So while FCX soared during last year's major HUI upleg as copper
prices fortuitously rocketed higher along with rising gold prices,
it doesn't make much sense to use FCX options for HUI synthetics.
Speculators looking to trade HUI options or close substitutes
are looking for leverage to the bull markets in gold and silver,
not the broader general
commodities bull. Since copper is not a precious metal that
has been long sought by private investors, its supply and demand
dynamics are vastly different than those of gold or silver.
With GFI's Marxist local government and forex problems and FCX's
trading dominated by copper movements, this once again leaves
Newmont Mining. Even though GFI and FCX have outperformed NEM
during various uplegs in this bull market to date, NEM still
remains the most HUI-like in its overall trading profile.
NEM has risen continuously in every major HUI upleg to date.
It has not surged prematurely and then ground sideways for years
like GFI nor has it ground sideways for years and then surged
like FCX. NEM isn't the flashiest company, but it is the
bluest of the blue-chip unhedged gold miners. Like the old parable
of the tortoise and the hare, NEM just keeps chugging along and
relentlessly marching higher upleg after upleg.
And since it doesn't have geopolitical or currency problems and
depends on no other underlying commodity than gold, I believe
that NEM has the best chance of finishing this long-term race
on top. Out of all three of the large HUI component companies
that dominate the index, NEM is the purest gold miner with the
fewest non-gold-related risks and complications. It is certainly
not a perfect HUI substitute, but it is definitely the closest
HUI substitute with a thriving options market today.
If you look at the first graph above NEM lagged both GFI and
FCX in bull-to-date performance terms. As this next non-indexed
conventional chart of just NEM and the HUI reveals however, the
indexed chart above doesn't tell the whole NEM story. NEM only
traded as high as 4x its bear-market bottom price in late 2003
primarily because it never went as low as GFI and FCX. The lower
a particular stock trades at its bottom, the larger its raw percentage
gains become over time due to the underlying math of launching
a new bull run off of low numbers.
Our second chart is zeroed and non-indexed and reveals
that NEM has tracked the entire HUI bull market to date exceptionally
well. The same four major uplegs and four major corrections shown
above are drawn in here too. Each of these important tactical
episodes has four numbers attached that outline NEM's performance
relative to that of the HUI's. All of these numbers look confusing,
but they are really simple and help us determine just how likely
NEM options are to act as valid HUI synthetic options in the
Please take a look at the actual NEM and HUI bull-to-date lines
in this graph from a pure visual perspective first, comparing
the geometry of the uplegs and corrections in NEM and the HUI.
The ups and downs in NEM really do track those of the HUI rather
well in its bull to date. After you have digested this graph
visually, I will explain what all these numbers are telling us
regarding using NEM options as HUI synthetics.
The first most important requirement
of using NEM options as a substitute for HUI options is that
NEM closely tracks the HUI's price movements. As this graph reveals,
in the HUI's entire bull to date the NEM price has followed the
HUI's major movements, entire uplegs and corrections, nearly
perfectly. And it has even conveniently mirrored the vast majority
of the HUI's short-term multi-week gyrations!
Almost without exception when the HUI is up NEM is up and vice
versa. This is very important because HUI speculators using NEM
options will be betting on major moves in the HUI via NEM calls
and puts. Since the NEM price has so closely tracked that of
the HUI's visually over the past four years or so, odds are it
will continue to closely track the HUI's price in the future.
So speculators can buy NEM calls when the HUI is due
for an upleg and NEM puts when it is due
for a correction.
This eyeball visual comparison is certainly important and greatly
buttresses the NEM options as HUI synthetics theory, but we really
can't know exactly how close NEM has tracked the HUI without
statistical analysis. In every major upleg and correction above,
four numbers are noted which statistically quantify the degree
to which NEM actually mirrors the behavior of the HUI. Each affects
the pricing of NEM options and hence their degree of usefulness
as profitably tradable HUI proxies.
The first number during each major upleg or correction, drawn
in green or red above, outlines NEM's relative gain or loss as
compared to the HUI's. For example, in the first major upleg
labeled 1, NEM moved 0.759x as far as the HUI itself did. During
this upleg the HUI ran up 113% in early 2001, so the 0.759 NEM
reading translates into an 86% gain for NEM. In the first correction,
the red 1.026 reading means that NEM fell 1.026x as far as the
HUI in the second half of 2001.
These total overall swings of NEM are very important for
NEM options pricing. In order for us speculators to buy NEM options,
someone else has to be willing to sell them to us. These options
writers assume potentially unlimited risk so they are very careful
with pricing their options. The farther an underlying security
tends to move, the greater their perceived risk. Options will
be far more expensive for a stock that has a 100% trading range
over the past year as compared to one that has only oscillated
In NEM's case, it tends to move less than the HUI. This tendency
makes perfect sense since NEM is the ultimate unhedged blue-chip
gold and far less risky than all of the smaller companies
in the HUI. It is not as speculative as the smaller components
and doesn't move as far. Actually this is good for options pricing
though, as the larger that NEM's average upleg and correction
movements are, the more expensive its options will be.
During all four major uplegs, NEM averaged gains of 0.675x those
of the HUI, about 2/3rd. This number isn't particularly bad although
it is a little lower than I would like to see it. In comparison
in upleg 4 discussed in the original "Synthetic
HUI Options" NEM ran 0.848x as far as the HUI, much
better. For options traders this means that we won't get as much
raw leverage via NEM options as we would via the HUI, but on
the bright side the NEM options should be significantly cheaper
than true HUI options would be.
During the four major corrections, NEM averaged losses of 0.875x
those of the HUI. Thus, NEM HUI synthetics offer more bang for
the buck as puts during corrections than as calls during uplegs.
Actually this is great news though, as one of the major drawing
points of HUI synthetic options is the ability of gold-stock
speculators to use them to profit even through the periodic HUI
corrections. Speculators can own leveraged gold stocks
outright during uplegs but sell them and buy NEM puts to continue
earning money when a correction is due.
The average major NEM move over all eight major uplegs and corrections
ran 0.775x that of the HUI. Thus, in terms of big swings NEM
options have been running almost 78% effectiveness as synthetic
HUI options in this entire bull to date. This really isn't too
bad in absolute terms and is actually outstanding when you consider
that there are really not any viable and highly-liquid alternatives
to the NEM options for riding major gold-stock uplegs and corrections
The second number, drawn in yellow, is the R-Square value for
each major move. R-Square of course is the NEM and HUI correlation
coefficient squared that statistically explains how much the
movement in the HUI explained the movement in NEM and vice versa
during a given major upleg or correction. Naturally the higher
the better for options traders in HUI synthetic terms.
During all four major uplegs, the average R-Square ran 82.1%.
During the four major corrections it ran 84.4%. Over the entire
bull to date, the average major-move R-Square weighed in at 83.2%.
These numbers aren't stellar, but they are still quite high and
indicate a very strong statistical relationship between NEM and
the HUI. With 83% or so of NEM's daily price movements directly
explainable by the HUI's, it makes a fine HUI substitute over
the entire bull to date.
I also find it very interesting that the R-Square numbers seem
to be generally rising over time, with the correlation of NEM
and the HUI growing stronger during recent major moves. If this
trend continues it is a good omen suggesting that NEM and the
HUI will continue to trade in lockstep in future uplegs and corrections.
The third number above, drawn in blue, represents the degree
to which NEM's average absolute interday volatility compares
to the HUI's. In the first upleg, the 1.040 reading indicates
that NEM was 1.04x as volatile as the HUI on average on a day-to-day
basis during this particular upleg. The closer this number gets
to 1.00 the better since volatility is a very important ingredient
for options pricing.
Options writers selling options to speculators face increasing
risks with increasing volatility. The more volatile an underlying
security, the higher the probability that they will face exercise
on their written options. Everything else being equal, the higher
the volatility profile of a stock the more expensive its options
generally cost. For example, if NEM was twice as volatile as
the HUI on average, its options would be much more expensive
than true HUI options. If this was the case it would sink the
whole synthetic HUI options thesis since NEM options would be
too expensive relative to their potential returns.
Thankfully though, NEM volatility follows that of the HUI's amazingly
closely! It averaged 1.014x that of the HUI's during uplegs,
0.906x the HUI's during corrections, and 0.960x overall. This
is great news for speculators that means that NEM options should
be priced very similarly to what actual HUI options would be.
With NEM's bull-to-date volatility profile running at 96% or
so of the HUI's itself NEM and the HUI are practically identical
in volatility terms.
The final number, drawn in white, is the offset. It records the
number of days between an interim HUI top or bottom and the corresponding
interim NEM top or bottom. If the HUI tops today, for example,
and NEM tops three days from now, it would be an offset of +3
days. If NEM topped 4 days ago while the HUI tops today, the
offset would be -4 days. Obviously we want major NEM interim
tops and bottoms as close as possible to actual HUI turning points
for trading purposes.
During uplegs, the average NEM offset was -1 day, just about
perfect. And three of these offsets were actually on day zero
which means that NEM topped on the very same day that the HUI
did. During corrections this average offset swelled to +6 days
but this was totally due to one anomaly in late 2001 when NEM
carved a slightly lower low 29 days after the HUI bottomed. If
this rare situation is ignored, the average offset is nearly
perfect on corrections as well.
Overall the average offset for major interim tops and bottoms
was only +3 days or so, and if that weird 29-day situation is
left out it falls down to merely -1 day. Thus, HUI speculators
buying NEM options can be fairly certain that major turning points
in the HUI itself will be accurately reflected in NEM within
only a few days on the outside. This makes it far easier to coordinate
NEM options trades with major uplegs and corrections in the HUI.
In summary, even in this entire HUI bull to date NEM options
appear to be excellent synthetic HUI options. NEM's eight major
swings since late 2000 have averaged about 78% of the distance
of the HUI's, largely due to its considerably lower risk as the
ultimate unhedged blue-chip gold. The R-Square correlation of
these moves was 83% on average, which is quite high over nearly
From the volatility-profile perspective absolutely crucial to
options pricing, NEM has run at 96% of the HUI's average absolute
interday volatility for its entire bull to date. This means that
the pricing on the highly liquid NEM options should be nearly
identical to what true exchange-traded HUI options ought to be.
And to top this all off, NEM tends to top and bottom within a
few days of the HUI so the synchronization of major uplegs and
corrections is outstanding.
Thus, even when we expand our synthetic HUI options inquiry to
include the entire bull market in gold stocks to date, NEM continues
to shine as the best available current proxy for HUI options.
Speculators wanting to leverage major uplegs and corrections
in the HUI should consider deploying NEM calls and puts as appropriate.
In both our Zeal
Intelligence monthly newsletter and Zeal
Speculator e-mail alert/update service I have been layering
in NEM options as HUI synthetics all summer. The idea behind
these trades for our subscribers
is that the fourth major correction in the HUI ended in early
May and hence the fifth major upleg is already
gathering steam. And I have high expectations for this next
upleg since the first four averaged +111% each!
Now since NEM has tended to track these major uplegs at 78% efficiency
bull to date, NEM stock itself could witness a gain in the 85%+
range. If this indeed comes to pass and transpires before expiration
on the majority of our NEM options contracts, multiple gains
of hundreds of percent will be achieved.
If you are interested in seeing which particular options contracts
I am layering in and knowing when I buy or sell more NEM options
as HUI synthetics in the future, please consider subscribing
today and supporting our research work at Zeal.
The bottom line is even over this entire bull market in the HUI
to date, Newmont stock has done a fine job of tracking this flagship
gold-stock index. Thus, the highly-liquid and extremely-easy-to-trade
NEM options chains effectively form the best synthetic HUI options
August 13, 2004
Adam Hamilton, CPA
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