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Earn Up To 36% As Gold Rebounds With This Income Strategy

Thursday, February 13, 2014 7:00 AM

It's been more than two years since gold prices peaked. Since then, precious metal prices have been in a well-defined bear market despite the widespread belief that the Federal Reserve's stimulus programs would naturally send them higher.

Ironically, as the Fed finally begins to taper its bond purchasing program, precious metal prices now appear to be bottoming. Although it may seem counterintuitive at first, the fact that gold is rallying right now actually makes perfect sense.

For quite some time, the Fed has kept interest rates artificially low and injected capital into the U.S. economy by purchasing massive amounts of Treasury bonds and mortgage-backed securities. Gold bugs claimed that these capital injections would lead to high levels of inflation as more dollars were forced into the financial system.

This didn't happen because the velocity of money was so very low. Despite the low interest rates, banks were not lending capital to borrowers, and businesses were not borrowing money for growth investments. In short, the cash was just sitting stagnant instead of being put to work to help the economy grow.

Today, however, the tide is beginning to turn. The U.S. economy is finally showing signs of a recovery, which in turn, is allowing the Fed to ease its stimulus spending. And the recovery in the U.S. market helps to increase the velocity of money, which has some investors beginning to worry about inflation.

As you can see in this chart, gold prices appear to have found support in the same area where they bottomed in July. After such a long decline and a bullish double-bottom formation, it is very likely that gold will mount a sustained rally as the U.S. economy picks up momentum, and this could be great news for gold mining stocks.

In particular, I have my eye on the Market Vectors Gold Miners ETF (NYSE: GDX), as it has already been trading higher this year. It is interesting to note that despite the broad sell-off in equities, GDX has been in a healthy uptrend. This may indicate that gold miners represent a haven for investors who are bailing out of traditional stocks, and they also represent an opportunity for us as income traders to employ a put selling strategy.

Today, we can sell out-of-the-money put options on GDX for an attractive premium. This is largely because of the overall volatility in the market, which has increased the risk premium for stocks and thereby option prices.

GDX is currently trading near $25.60, and the March $25 puts are trading near $0.90 a share ($90 per contract, which controls 100 shares). Selling the March 25 puts obligates us to buy shares of GDX at $25 provided the ETF is trading below this level when the puts expire. Given the positive dynamics for gold prices, which will naturally support better earnings for gold miners, I am more than willing to buy GDX at this price.

But it gets even better. Since we are receiving $0.90 a share to sell the puts, we will actually be buying GDX at a net price of $24.10 a share ($2,410 per contract). That is a 6% discount to the current price and definitely an attractive spot to build a long position.

Of course, GDX could continue to trade higher from here. In this case, we would not be obligated to buy the ETF and would be able to keep the $0.90 per share that we received from selling the put. Since we will need to set aside $24.10 per share of our own capital in case we are assigned the shares, this represents a 3.7% rate of return over the next 38 days, an annualized return of 36%.

Action to Take --> Even though GDX's dividend yield is low, investors can use the strength in gold mining stocks -- and this put-selling strategy -- to boost their income significantly.

This article was originally published at ProfitableTrading.com:
Unlikely Income Play Could Yield 36% a Year as Gold Rebounds

Zachary Scheidt 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.