Gold Stocks: A Savvy Investment?

Gold stocks represent one of the best way to buy into gold without tapping into the volatile commodities market.  Gold stocks offer liquidity that isn't available in the physical gold market. Gold stocks pay dividends and do very well when gold prices are rising, as their profit margins usually grow disproportionally larger than the hike in gold prices.

High Cost Mines

Basic economics dictate that the market price of any good must be higher than all the costs of conducting business in order to survive. High cost gold mines work with gold that is either hard to bring to the surface or that is so thin that it takes extra work hours to sift through all the rubble. Either way, high cost gold mining stocks allow you to profit heavily when you think gold prices will rise.

Consider that an ounce of gold is selling for $1000 on the open market. One high cost gold stock you are considering is operating at an expense of $980 per ounce of gold, thus they make only $20 in profit per ounce that is produced. The company sells at a great price to earnings multiple of 15, cheap for a stock in the commodities market. Assuming that you think that the price of gold will rise, you buy stock in the gold mine and hope for the best.

Three months later, gold is now selling for $1100 per ounce, up 10% from where you bought the gold mining stock. Since gold is up 10% in price, this stock should be making 10% more right? Wrong, the gold mining company is now making $120 per ounce as opposed to $20 per ounce. That's a six-fold increase in profit just on a 10% rise in gold. Now the company is operating at a PE ratio of 2.5, since their operating margins jumped by 500%. In the stock market, there is simply no way that a stock would ever sell for a PE of 2.5; even if it traded at a PE of 10, you'd still be set for a 400% increase in share price.

Using Stock Options

Taking a position in gold stocks can also be done with stock options on gold stocks. Stock options allow you to control stock of a gold company while limiting the downside in case the price of gold falls. With the above example in mind, consider another way to control gold shares.

Less risk with options?

Buying gold stock options gives you the profits if gold rises but also controls losses in the case of decline. Stock options work in such a way that you can never lose more than you have invested, buying 100 options on stock means that you'd control 100 shares of stock for just the price of the premium. If a stock is trading for $50 per share it would be possible to get $50 call options 2 years out for somewhere between $3-5 each. While this seems steep, you'd only be able to lose $5 per share of stock while controlling the stock the whole time. Even if the stock tanks to $40 per share, you would only be out $5 per share. If it rose to $75 per share, you'd make $20 per share with a $5 investment. Options allow you to hold stock at huge losses without losing any more capital; a great way to play commodity based stocks.