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Michael Fowlkes' Analyst Insights

Options and ETF Analyst Writer
Michael Fowlkes
Author Bio

May 20, 2013 - How to profit from a weak mining sector

While the overall stock market has been strong during 2013, one of the sectors that had been particularly weak through the first quarter of the year was the mining sector.

Looking at the SPDR S&P Metals & Mining (XME) ETF, you can get a clearer picture of just how dismal the sector has been. At the start of the year, XME was trading at $45.02, but fell by 23.8% before hitting a new low of $34.30 on April 18.

Considering how poorly the sector had performed during the first quarter of the year, expectations were not high for the current earnings season, and those low expectations proved to be accurate.

Let's take a look at a couple of the biggest mining stocks in the ETF, and review their earnings numbers.

Its biggest holding is Cloud Peak Energy (CLD). The company reported Q1 earnings of $0.11 per share on April 30, well below the $0.27 analysts had forecast. Following its big earnings miss the stock has traded down 4.1% and has yet to find its footing.

Royal Gold (RGLD) is the second biggest holding. With the way gold has been trading in 2013, it should come as no surprise RGLD has been weak. On May 2 the company reported fiscal Q3 earnings of $0.37, which was below the $0.39 that analysts had forecast. The stock was already weak, and the earnings miss has resulted in another 6.7% drop, taking its year-to-date loss to a massive 39.3%.

The next biggest holding is Newmont Mining (NEM). Like Royal Gold, Newmont was already suffering from the weakness in gold, but missing analyst estimates for its first quarter on April 29 has only compounded its problems. The stock is down 9.9% since its earnings report, and 33.7% year to date.

The list of underperforming mining stocks goes on and on. Until we see a bottom in precious metals, the entire industry is going to remain weak. It is getting more expensive to get metals out of the ground, and as the prices for those metals drop, mining companies are going to struggle.

Even with ongoing losses in its three biggest holdings, XME has managed to find support and make back some of its recent losses since hitting its 52-week low in mid-April. Despite its recent trading we expect to see ongoing weakness in the sector through the remainder of the summer.

With so much weakness across the industry, we are taking a bearish stance on it, but we also realize that with such big losses during the first part of the year, when the sector finds support and moves higher it will most likely make a strong move. As a result, we want to not only hedge any bearish trade we take on the miners, but also ensure that we build in enough downside protection to prevent losses should we see a big correction to the upside.

A good way to play the sector would be with a bear call spread on SPDR S&P Metals & Mining (XME). A nice hedged trade on XME would be the September 42/45 bear call credit spread for a credit of $0.40. In this trade, you would sell the September 42 call while buying the same number of September 45 calls for a credit of 40 cents. This trade has a target return of 15.4%, which is 44% on an annualized basis (for comparison purposes only). With XME currently trading at $37.35, this trade has 13.5% downside protection.

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