As gold and silver prices exit a two-year bear market and begin to turn higher, we're seeing some great opportunities in precious metal mining companies.
This demand should continue to rise in 2014 as China braces for what could be a very painful contraction in its economic growth rate. A recent Bloomberg article noted that Chinese bond defaults were now "unavoidable," and the country's shadow banking system has been referred to as a "ticking time bomb."
With a white-hot real estate bubble posing significant risk, and China's policymakers expanding the allowed trading range for the yuan, Chinese investors have legitimate reasons to want to protect their wealth against a potential debasement of their currency. Buying gold is one way to help protect their purchasing power, and as long as the country remains on unstable economic footing, I expect demand for gold to increase.
Not only is this demand good news for precious metal miners as they will be able to sell production at higher prices, higher gold prices should indirectly benefit equipment makers who supply miners with the heavy machinery.
Long-term projections for gold prices will have a material effect on the economic viability for individual gold miners. When gold prices were steadily trading lower, threatening to move below the $1,200 per ounce price point, miners cut back on some specific high-cost operations, as these projects were no longer profitable at that price point.
However, if gold prices continue to appreciate, many of these projects could be reopened, and new exploration opportunities would once again be worth the cost of development. As gold demand from China builds, I expect miners to adopt a bullish long-term perspective on gold prices and take on more risk, opening shuttered operations and expanding development projects. This increase in operations will require more equipment, which is great news for companies like Caterpillar (NYSE: CAT).
Shares of CAT have been moving steadily higher over the past few months, climbing from a low of $82 in November to a current price near $96. As miners start to expand operations, I expect Caterpillar to receive new orders for equipment, which in turn, should bolster investor confidence. Since CAT is already in a strong bullish pattern, it is not a stretch to say that the stock should hold up well in an environment that features rising demand for its equipment.
Today, we have a chance to set up an income trade that will generate 20% a year by selling puts against CAT. The CAT April 95 Puts, which expire in four weeks, are currently trading near $1.45 per share.
By selling these puts we obligate ourselves to buy 100 shares of CAT per contract at the $95 strike price. This purchase price represents a slight discount to the current share price, and when you consider the fact that we received $1.45 in premium from selling the puts, our net cost is actually only $93.55. Given the long-term positive outlook for CAT, and the strong boost in income it could receive from precious metal mining companies, I would be happy to buy shares at this price.
If CAT remains above the $95 level, we will get to keep the $1.45 per share ($145 per contract). Compared with the $93.55 per share ($9,355 per contract) that we will need to set aside in case we are assigned the shares, this represents a 1.5% return. Since this return can be booked in just 28 days, the trade represents a 20% per-year rate of return.
One thing to note is that Caterpillar pays a $0.60 quarterly dividend, which represents a 2.5% yield. The next dividend is expected to be paid the week these puts expire. As put sellers, we will not be eligible to receive the dividend payment, but the stock could drop by $0.60 on the day the stock goes ex-dividend. This makes our puts just a bit more likely to be exercised. But with CAT paying an attractive dividend, on top of the strong business outlook, I would be happy to pick up shares at a net cost of $93.55.
This article originally appeared on ProfitableTrading.com:
Alternative Gold Play Could Yield Up to 20% a Year in Income