HUI and Gold Price: Best Future Return Likely In Junior Miners

Source:

...The public consensus has accepted gold price in the range between $550-$650, at the current level, a much more positive sentiment than 2004. As a result, I expect very little downside and risk by holding HUI at this point...

If my view on 1:1 return in % between HUI and gold are correct, then investing in HUI doesn't generate any leverage of return, as many people would have expected, and we won't see the same movement or % gain again during the previous $38-$250 run. It is obviously incorrect to expect return of an in the money call to match an out of money call due to the different risk profile.

On short term basis, HUI has deviated from gold from time to time. The longest deviation happened and lasted for the whole year of 2004. Gold was able to creep new highs, but HUI couldn't and lagged behind. I think the main reason is due to the lack of arbitrage mechanism between HUI and gold. In order for option arbitrage to work, we need put call parity, or c-p = S-X. For example, if call is undervalued, we can buy call, short put, short stock, buy U.S. treasury to generate a risk-free arbitrage profit. However, this is not true for HUI, since there is not a good basket of companies or index which correlates perfectly but inversely to gold.

Why is the deviation in 2004 then? I believe HUI reflects people's expectation and perspective on gold. In 2004, even gold rose slowly and made new highs, no one believed that gold would stay at that level of $400-$450 very long, the general public view was that gold would eventually go back down to $300-$350 level (again near the strike price). HUI as a composition of gold miners, correctly reflected the mass view at that time by discounting the future earnings, and traded at "discount" to gold. This, however, won't happen in stock option due to the arbitrage discussed above. Will this deep discount happen today? I don't think so. The public consensus has accepted gold price in the range between $550-$650, at the current level, a much more positive sentiment than 2004. As a result, I expect very little downside and risk by holding HUI at this point.

Related Articles

Get Our Streetwise Reports Newsletter Free

A valid email address is required to subscribe