The Bullish Case for Gold Miners with GDX Call Options

OK, we'll say it -- even though it's a hackneyed and often trite expression: "What a difference a year makes!" In this instance, we're referring to the huge inflows in early 2016 into the SPDR Gold Trust ETF (GLD), as its sharp 2016 rally began to take hold: Inflows of almost $1 billion in January 2016 that then exploded to $6.8 billion by the end of the first quarter. Contrast this, if you will, with the net outflows (to the tune of $866 million) from GLD so far in 2017 -- despite its 3.5% year-to-date gain and the 6% rally (and actually as much as 8% just a few days ago) off its Dec. 15 lows.

While outflows from ETFs represent headwinds to upside progress, for funds that are nonetheless powering their way higher, these outflows can also indicate: 1) a powerful level of underlying investor demand; and 2) the potential for a runaway rally, should ETF investors reverse course and begin to accumulate (which they will almost always eventually do when a widely held asset rallies past the point at which there is too much pain associated with missing out on further upside).

Though not widely discussed, the inflow situation for VanEck Vectors Gold Miners ETF (GDX), which invests in the shares of the gold miners, has been far more stable than that for GLD. In fact, since January 2016, GDX has been more or less in a constant "state of inflow." This is rather remarkable, given that GDX exhibits about triple the volatility of GLD -- and given there is nothing John Q. Investor finds more upsetting (or which can more powerfully stimulate his propensity to click on that "SELL" icon) than downside volatility. Perhaps this is a function of the fact that assets under management for GDX are just one-third of the asset level for GLD, but it is a fact that while investors let loose with $4.9 billion in outflows from GLD over the post-election period through year-end 2016, they calmly added $425 million to their GDX positions (source of all fund flow information: etf.com).

In our view, the aforementioned backdrop could spawn a situation in the weeks ahead of "compounded upside leverage" for GDX holders, in the event GLD flows should once again turn strongly positive: The leverage from an inflow-stoked GLD rally translating into GDX gains at a multiple of 2.5-to-1 (or even 3-to-1) relative to GLD. (Examples: Over the six-month period from 1/28/16 to 7/29/16, GDX gained 78.8% on a rally of 22.8% by GLD; GDX has gained 11% year-to-date through 1/23/17, compared to a 3.5% gain for GLD.)

Of course, however strong the case for leverage, there must first be gains to which the leverage can be applied. And our appetite for recommending a call option on GDX was very strongly stimulated by what we see as the bullish implications of the accompanying one-year daily chart. Specifically, the recovery by GDX from its Dec. 20 lows has proceeded in a very constructive manner from a technical perspective, and GDX now finds itself perched atop multiple levels of support in the form of key moving averages. And while GDX has some work to do in clearing resistance in the vicinity of $25, once accomplished, the sailing is pretty clear until GDX reaches the upper 20s -- levels that would represent the opportunity to achieve a 200% gain on our recommended call position.

At Friday's closing price levels, our recommended GDX call would achieve its target profit of 200% on a rally by GDX over the holding period to just shy of $29. And this leverage is enhanced by the fact that the implied volatility (IV) underlying GDX option premium is currently lower than 97% of such readings over the past 52 weeks (source: Trade Alert).