Fri Feb 17, 2006: A 25% C.D. Backed by Gold?

Well, not exactly. A Certificate of Deposit (C.D.) pays you a fixed rate of interest income, which is guaranteed, in addition to your principal being guaranteed, both by the issuing bank. Of course, any guarantee is only as good as the bank behind it. But in the case of C.D.'s the Federal Deposit Insurance Corporation (FDIC) also insures them.

So what I'm going to talk about here, writing covered calls on a gold mining stock, cannot compare to an FDIC insured C.D. for safety. Remember there are two types of investment return. One is the return on your money. The other is the return of your money!

Owning shares of stock in a gold mining company does not entitle you to redeem them for any actual gold. Of course, these days, neither does owning dollar bills. In the past United States Certificates (dollars) could be exchanged for gold, or for silver. Not anymore. Today's Federal Reserve Notes (also called dollars) can only be exchanged for, well, more dollars. They have no intrinsic value. They are "backed" by nothing but the hope that someone else will accept them as money. Since dollars are a popular form of money, most people don't even think twice about that.

Gold is a popular form of money too. Lately it has become more popular. When I say that shares of a gold mining company are "backed" by gold, I mean to the extent that gold remains popular as an investment, that will tend to support the price of the stock, assuming the mining company runs its business in a profitable manner.

A one-year C.D. currently might offer you a return of 5%. Not very exciting, but again, there is that "return of principal" factor isn't there?

A one-year covered call option on Royal Gold Inc. (NASDAQ-RGLD) currently provides a return on principal of nearly 25%. Wow, five times as good! But with no guarantee the stock price will maintain its value.

Choices.

I bet most of you could guess what my choice is, but your money is your money. On the other hand, some investors wouldn't be satisfied even with 25% per year. Covered calls are not aggressive enough for them. They choose other strategies.

In my opinion it's always prudent to keep the majority of your money in guaranteed investments such as C.D.'s, money market funds, and bonds. Note that while all of these are "guaranteed" by somebody, usually only the C.D.'s are insured.

Risking a portion of your investment funds in more aggressive investments with higher potential yields is reasonable if you understand the risks.

For those of you who are interested in returns available from RGLD covered calls, let's look at some details below.

I'm taking about 35.00 strike price covered calls for January 2007 so it's actually a little less than a year, eleven months. And it's actually a little less than 25%, 24.7% to be precise based on today's closing prices and ignoring commissions.

If the stock goes down you could lose more than 24.7%. Always keep that in mind.

If it goes up you could make more. RGLD closed today at 33.37. If it gets called away at 35.00 next January your total return will be 30.7%. This is a slightly out-of-the-money covered call.

Another choice would be to sell an in-the-money call, the Jan 30.00, which pays only 21.6% but offers some downside price protection because even if the stock goes down to 30 your return is still 21.6%. In fact even if it goes up your return is still 21.6%. Only if the stock goes below 30 does your net return start to decrease, while in the case of the out-of-the-money call any price decline will have that effect.

Quiz question for today: What are the breakeven points for each of these two choices?

No need to peek in the back of the book or purchase the teacher's edition, here are the answers:

33.37 - 6.60 = 26.77 and 33.37 - 8.70 = 24.67

So the Jan 30.00 call is safer.

I know, that was an easy quiz. They'll get much harder in upcoming commentaries on more advanced option strategies; I can guarantee that. So invest some of your profits in a top quality thinking cap.

Incidentally, a $20 bill from 1928 says "This certifies that there has been deposited in the treasury of the United States of America twenty dollars in gold coin payable to the bearer on demand."

Today's $20 bills just say "Federal Reserve Note."

You can see photos of some of the old "real money" along with an excellent article on the subject at www.friesian.com including a photo of that 1928 gold-backed $20 bill.

Until next time, best of luck with your C.D.'s! (and your covered calls)