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Thursday, October 18, 2012 - 07:00
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Thursday, October 18, 2012 - 07:00

Pullback Could Provide Prime Buying Opportunity in This Gold Stock

Thursday, October 18, 2012 7:00 AM

One noted CNBC analyst/entertainer is fond of saying "There's always a bull market somewhere," and he is correct that at least one stock market sector or country will go up even in the worst bear market. This is especially important to remember at times like this, when economists and traders are struggling to make sense of the news from around the world. Some are raging bulls while others are serious bears, but few market commentators are neutral on the outlook for the next few months. With so much uncertainty, traders should focus on value and buy stocks in sectors that have a rational reason to go up even if the majority of stocks fall.

Uncertainty has always been one of the reasons traders buy gold, and that underlying psychology probably won't change anytime soon. Some gold stocks will benefit from the gold bugs' desire to hedge risk, but traders need to be selective. Many of the smaller mining stocks are little more than a story about gold that will be discovered one day. Traders should stick to major companies that have proven reserves and demonstrated the ability to deliver profits like Newmont Mining (NYSE: NEM), one of the oldest and largest mining companies in the world.

Newmont has operations in the United States, Australia, Peru, Indonesia, Ghana, New Zealand, and Mexico, with proven and probable gold reserves of about 98.8 million ounces. The company has been operating since 1916, and has been publicly traded since 1983. Over the past 29 years, NEM has gained more than 950% while gold has appreciated by about 350%. NEM could be a buy for traders wanting to add gold to their portfolios, but the chart shows that a short-term pullback is possible, and by waiting we might be able to buy at a better price.

On the weekly chart, we can see that NEM completed a double-bottom pattern and quickly reached the price target for that pattern. After reaching a price target, stocks often pull back. Given the stochastic sell signal in NEM, the chances of at least a short-term price decline in NEM seem high.

While waiting for a pullback, traders can sell put options on NEM to earn income. If the stock falls below the strike price on the put, the option will be exercised and put sellers will be obligated to buy the stock. Selling November $50 puts would allow us to buy NEM at an attractive price if the stock does fall. If the price of NEM is not below $50 at the expiration date in November, put sellers keep the premium as their profit. With these puts selling for about $0.42, that would offer income of about 4.2% on a margined position for a five-week holding period, which is more than 40% a year on an annualized basis.

At $50, NEM would be trading at less than 11 times next year's projected earnings. In the future, analysts are expecting rapid growth in NEM's earnings. Current estimates are for earnings to more than double every year for the next five years, on average. That could be optimistic, but earnings for miners in general are expected to grow at about 10% a year in the future.

If NEM matches the growth rate of its sector, the stock should trade with a price-to-earnings (P/E) ratio of at least 10, making $50 a share a good buy price for a company expected to earn a little more than $5 a share next year.

If the options expire worthless, traders can continue selling puts on NEM in the future to generate income. When the worst-case scenario in a trade is to own a fast-growing company at a P/E ratio of 10 or less, the trade seems to be a low-risk way to profit in an uncertain market.

Action to Take --> Sell NEM Nov 50 Puts below 50 cents a share. Do not use a stop-loss. If the puts expire out of the money, the profit would be equal to 100% of the premium. If the puts are exercised, you will buy NEM at less than $50 a share.

This article originally appeared on TradingAuthority.com:
Pullback Could Provide Exceptional Buying Opportunity in This Gold Stock

does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.