SK Options Trading: Analysing the Geopolitical Risk of Gold Mining Stocks in the HUI

Introduction

The following article contains analysis of the performance of gold mining stocks in the HUI in relation to their geopolitical exposure. We have used geopolitical risk ratings to calculate the exposure of each of the stocks based on the locations of their currently active operations and reserves. This has generated a value of production based geopolitical risk, a value for the geopolitical risk of the proven and probable resources of that mining company, and an overall average geopolitical risk rating. All research is based on the one year time period of 2012 to keep things simple. These geopolitical risk ratings have been mapped against performance to find information that could be used to trade a gold stocks portfolio and increase overall profits. Therefore this piece covers 3 main points:

• The geopolitical risk of gold mining stocks relative to performance
• Grouping of mines by risk, and the performance of these groups
• How to profit from the analysis

We have long been of the view that gold stocks perform poorly on mass, and therefore have been an advocate of being short gold stocks. This piece shows how one could be short most gold stocks, but long the gold mining companies that have low geopolitical risk and therefore increase the profitability of an overall short gold mining stocks position.

We have shown how various combinations of long and short positions would perform in a portfolio, as well as how various pairs trades would perform. These have been compared against similar positions, such as being simply short all gold mining stocks in the HUI.

Production Based Analysis

The above graph shows the correlation between the performances of the stocks in the HUI gold miners’ index with their production based geopolitical risk values. A correlation coefficient of -0.45 is present, indicating a moderately strong negative correlation is present; the R² value of 0.20 means that 20% of the variance in performance could be explained by the stocks geopolitical risk.

The inverse correlation present is not strong enough to show tradable information. All that one could glean from this information is that as geopolitical risk increases the probability of the underperformance of gold stocks; hardly game changing information. Therefore we move to the next section to analyse the performance of gold mining stocks relative to the geopolitical risk of their proven and probable gold reserves.

Resource Based Analysis

The graph below shows that resource based risk correlates with performance in the same way that production does. The R² value of 0.25 is slightly higher than in the production based method, but it is not a significant enough change to mean that the correlation is one that could be traded upon. The correlation coefficient of -0.50 is lower, indicating a stronger negative relationship between the variables than in the production based analysis, but only marginally.

The correlation is not strong enough to be traded upon, however this resource based analysis show three clear groups to be present within the gold mining sector. There is a low geopolitical risk group present, the majority stocks of which appear to perform well. Next is a moderate geopolitical risk group in which the majority of stocks perform worse than the stocks in the low risk group. Finally there is a group that appears to have high geopolitical risk, in which the stocks perform within the range of the moderate geopolitical risk group.

From this section we determine that the correlation between geopolitical risk and the performance of gold mining stocks is not strong enough for it to be traded upon, however the grouping presented by the resource based analysis is potentially tradable and will be examined further.

Grouping

Resource Based Groups

The graph below shows the gold mining stocks of the HUI grouped by their geopolitical risk rating. As before, resource based geopolitical risk is mapped against the performance of the stock.

The stocks in the three distinct groups shown in the graph above have been sorted in the table below. The numerical rating of each geopolitical risk group has been shown also. 

It is at this point that the analysis becomes useful from a trading point of view. All, bar one, of stocks in the low risk group had positive performance in 2012, meaning that if one wished to benefit from a rise in gold stocks then it would be logical to only invest in those that had reserves in low risk areas.

We can also see that both moderate and high risk groups performed poorly, with Yamana being the only company in these groups to have positive performance last year.

Production Based Grouping

Resource based analysis has provided us with clear risk groups, using these groups we sorted the stocks using their production based geopolitical risk values. The graph and table below show these results.

The stocks in each group remain the same, with the exception of Coeur d’Alene. This stock changes from having low geopolitical risk to moderate.  An increase in risk from reserves to production may indicate that Coeur d’Alene is moving its operations to areas that carry lower geopolitical risk, which in turn could indicate future positive performance.

Due to the change in risk group by Coeur d’Alene, we generated an average overall geopolitical risk rating, based on both the production and resource data. It is this overall measure that we will use as the geopolitical risk value when we investigate the performance of various portfolios and positions that can be built from this study.

Overall Geopolitical Risk Grouping

The result is that the grouping remains the same as in the production based analysis, meaning that we group Coeur d’Alene as having moderate geopolitical risk overall. The information in the table above is now very useful from a trading point of view; overall low geopolitical risk gold mining stocks perform positively, and stocks with high geopolitical risk perform negatively. The majority of the stocks with moderate geopolitical risk overall perform negatively, meaning that other factors, such as management, have pushed up Yamana into positive performance. We have examined how could use this information in a portfolio through various trading strategies in the next section.

Applying the data to a portfolio

The only thing an investor is interested in is the potential return of a particular trade; this section shows the possible performance that could have been achieved based on the findings covered thus far. The low risk group performed positively; therefore in this investigation all trades on this group will be long. The moderate and high risk stocks performed poorly, thus all trades from these groups in this investigation will be short.

The above chart shows how each of these positions would affect the overall portfolio with an equal portfolio allocation of 6.25%. For example, a long Agnico Eagle position would have gained 39.67% in 2012, if one had allocated 6.25% of their portfolio to that position it would have added 2.48% to their overall portfolio. Therefore the above graph shows how each individual position would have affected your portfolio in 2012. Those results add up to a total return of 15.34% in 2012.

Alternatives considered

If one held a view, such as ours, that gold stocks perform poorly on mass they could simply have gone short HUI, GDX, or GDXJ instead of taking the positions shown above. The graph below shows how those positions would have performed relative to being long low risk stocks and short high to moderate risk stocks in 2012. This portfolio is labelled “LLRSHMR”.

As you can see, the benefit of using geopolitical risk analysis, as opposed to a simple short HUI position, would have been a gain of 3.6% to your overall portfolio. It also outperforms GDX by just under 8%, making it a better trade in both cases.

Using HUI Weightings

 The HUI uses different weightings for each stock, not an equal allocation as we have used above. We have completed the same analysis of how a portfolio would perform using those weightings here; the performance is marginally better, with the LLRSHMR yielding 16.92% over 2012.

Both Portfolios outperform the alternatives, however using the HUI weightings the gain become 16.92%, which is 5.18% better than a simple short HUI position. Both equal and HUI weighted positions would take the same amount of time to execute as a short HUI position. Therefore as both outperform a short HUI position, applying this data to your portfolio should increase your gains regardless of portfolio size.

Below, the graph shows how each of the portfolios described would have performed through 2012 compared with the simple short stock positions that one could take as an alternative. The positions take a similar path throughout the year; an expected result given that many of the positions are the same.

Being long low risk, short high and moderate risk portfolio with HUI weightings returns 5.18% better than a simple short position. This means that last year one could have leveraged themselves 44% over a short HUI position, and 81% over a short GDX position.

Pairs Trades

The low risk stocks all moved up, and the high risk all down; therefore we have considered a pair’s trade to go long low risk stocks and short high risk stocks. Thus being long Agnico Eagle, Hecla and New Gold whilst being short Iamgold and Randgold. The table below shows the different trades that would have to be opened with an equal allocation to execute this position, as well as their returns.  

Each one would have returned a profit, the most profitable being Long AEM/Short IAG for 68.65% annualized return in 2012. The graph below shows how each of the trades would have performed individually.

The graph below shows how the Long Low Risk/Short High Risk pair trade would have performed through 2012, staying in profit after April. This trade would involve equally allocating funds to each of the pairs trades above. The overall return is considerable at 33.78% in 2012.

Conclusion

There is an inverse correlation between the geopolitical risk of the stocks in the HUI and their performance; however this correlation alone is not enough to present an underpriced option on geopolitical risk. Gold mining stocks separate into three groups based on geopolitical risk; the performance of the stocks within those groups is largely the same and thus provides tradable information. This information, if traded upon, would have generated consistent profits overall in 2012. Not only is the information profitable, but one could gain leverage of over 80% on a short GDX position for a decrease in overall risk.

Through the use of a Long Low Risk/Short High Risk pairs trade, one would have generated returns twice as high as a short HUI trade, and more than three times a short GDX trade. Therefore the use of geopolitical risk ratings of gold mining stocks should always be considered when one opens a trade, whether long or short, on these equities.

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