#writing Portfolio management is like producing a rock album - both arts require mixing different inputs to create something special, even if imperfect. This insight sets up a detailed exploration of a real-world gold mining stock trade that demonstrates how balancing various market factors, just like balancing sounds in the studio, leads to better investment decisions. --- **February 17, 2025** I've never done it, but I've watched enough rock documentaries to know that producing an album in a studio is a unique art form. You have your inputs—the drums, guitars, bass, vocals, etc.—that you mix together in different ways, experimenting to get that specific sound you're looking for. Almost by definition, it can't be perfect, and depending on your view of digital music, shouldn't be perfect. But if you can strike the right balance of sounds, you've created something special. Portfolio management is very similar. You have different streams of risk and return that you're trying to balance to build something that will produce favorable risk-adjusted returns. Unfortunately, we tend to focus more on the science of portfolio management than the art, but we shouldn't lose sight of the fact that perfection is not attainable. Maybe, just like with music, it shouldn't be the goal—imperfection means it's real, means it's human. We talk a lot in this space about [[Decision-Making]], and one can't be blamed for mistaking good decision-making with a pursuit of perfection. Kris said it well last week that ["decision-making is a practice that has structured inputs"](https://moontower.substack.com/p/value-over-replacement) when he was describing what option theory teaches us about decision-making. Just like an album has its structured inputs, we have the structured inputs of risk and return in the markets. The most basic set of inputs is the individual stocks you can select from to build a balanced portfolio. From there, you can venture into other asset classes via indices—groups of stocks or other securities linearly tied to bonds, commodities, foreign companies, etc. These indices open up additional dimensions of risk and return based on things such as construction methodology and rebalancing frequency, while offering expanded access to additional streams of risk and return. While venturing further into derivatives offers access to non-linear risk and return streams based on the underlying exposures. The portfolio manager is like the producer, sitting in front of the [Neve Console](https://en.wikipedia.org/wiki/Neve_80_Series), playing with the knobs to find the right balance of sound—or in this case, risk and return. Today, we have no shortage of fancy theories and practices in portfolio management and quantitative finance that seek to find the most "efficient" portfolio possible. However, many of these theories make simplifying assumptions that are akin to limiting the producer to making the album without drums. It's certainly possible, but it's an incomplete form of art. We constantly face this sort of tradeoff in life and the markets: simplicity versus complexity, precision versus practicality, cost versus benefit, focus versus optionality, [[CHG Issue 178 The Age of the Generalists|specialist versus generalist]], and so on. To see this in practice, let's look at a trade I did last week. This is not investment advice or any sort of recommendation—it's not even a trade based on value or a view; it was a portfolio management decision. What I did worked for me and my portfolio and probably doesn’t work for you, or your portfolio so don’t take this as any sort of recommended course of action. It wasn't perfect, but it balanced a set of needs I had with options available in the market. The usefulness for you, dear reader, is in the process and framework I used to mix different considerations into action. That's the beauty of life and the markets: what works for me probably doesn't work for you, but we can all use the same mixing console, just with different settings, to build our own works of art. Last week, I swapped my holdings of Newmont Mining (NYSE:NEM) for August ATM calls on a delta-neutral basis. Gold has been on a tear recently, and I have a large position in gold and gold miners that I wanted to rebalance. The low-volume advance with weak structure had me attuned to the growing risk in gold as it advanced, which was the genesis of this trade (additionally, Alex Campbell recently [analyzed the fundamental supply-demand picture in bullion](https://www.campbellramble.ai/p/gold-goes-west) which helps explain some of the market action we have seen). ![[Pasted image 20250216185913.png]] While GLD is trading at new highs, the miners are not. GDX is nearing its 2020 high but still well below its 2011 high. The miners give you levered exposure to gold, but you also have an operating company attached. In the case of the miners, these operating companies are not especially well run, which explains the divergence with gold. This also causes the miners to trade with higher volatility than GLD. ![[Pasted image 20250217100853.png]] While I wanted to pare down my overall exposure to gold, I didn't want to give up too much upside given that the primary trend is still higher. Naturally, reducing the higher-volatility NEM single-name exposure would lower the overall risk exposure of my gold holdings without lowering the nominal exposure too much. However, with NEM well off its highs, the natural pull of mean reversion could be supportive of NEM versus GLD during any GLD pullback. Additionally, NEM pays a 2.2% dividend yield that is tied to the price of gold, while GLD pays no such dividend. Given all of the above, the logical move was to sell the NEM shares and replace them with call options on a delta-neutral basis. This would maintain my overall risk exposure while lowering my total notional exposure to gold, providing downside protection. Selling shares and buying calls delta neutral is effectively a long put position, which means that while on the surface this idea seems perfect, there is a cost to it. First, I forgo the NEM dividend; however, the implied forwards of the August options allow me to finance my position (I have the same delta exposure but have freed up cash) at a below-market financing rate that roughly equals the dividend yield I am forgoing. Second, since I have basically bought insurance, there is a cost for that insurance, measured through the implied volatility of NEM. Unfortunately, the implied volatility of NEM has increased recently, as we can see in the chart below. ![[Pasted image 20250217084550.png]] This isn't surprising given our concerns and the [fundamental picture](https://www.campbellramble.ai/p/gold-goes-west), and it shows we aren't the only ones thinking along this line—which is both confirming and concerning. However, a closer examination of the term structure shows that long-dated volatility remains low and the term structure is deeply inverted. ![[Pasted image 20250216190820.png This sort of term structure reveals that the market is concerned in the short term but not in the long run. When looking at implied volatility, we also need to consider the skew, or the difference in implied volatility from ATM and OTM strikes. ![[Pasted image 20250216190758.png]] As we can see in the chart above, the blue lines are the August implied volatility smile today and one month ago, and the orange lines are the March implied volatility smile for the same dates. There's a lot of information in this chart, but we can summarize that near-term volatility and skew have increased over the past month, while long-dated volatility is roughly unchanged with downside skew higher and upside skew lower. This is the sort of spot-vol correlation dynamics we would expect to see as investors start to hedge their downside exposure, as I am trying to do. Before we can glean a full picture of the cost of these options, we need to see where realized volatility has been. Chart 3 above shows implied volatility (white line) increasing recently while realized volatility (orange line) has been decreasing. Generally, this is not a good picture for option buyers because you're paying a much higher price in terms of implied volatility than has been realized recently—in other words, the volatility risk premium is high, which usually attracts option sellers. However, if we look at the level of realized volatility, approximately 35%, we can see that it's roughly the same as the implied volatility of the August options. Therefore, the August options look fairly priced while the March options look rich, which is one reason we focused on the August expiry. Another downside to owning calls instead of the underlying is that the calls expire, which means our upside exposure is only good for the next six months. But I'm okay with that because, given the fact that NEM is mid-range, if it doesn't move to the higher end of the range or break out higher, the odds increase that it will see a countertrend move lower. Additionally, if the term structure remains inverted, the implied volatility of the August options will increase as they near expiration, ie. rolling up the term structure. Finally, given the levered nature of miners to the gold spot price and the potential for a crash up in gold, we could see call skew in the miners expand on an upside breakout—something that is not currently priced into the August call options. If we were to boil down what we achieved with this trade, it was replacing downside exposure with gamma through increased upside leverage, and the cost was that we have a six-month shot clock on this position. If NEM trades off, we can dynamically hedge our synthetic put position and buy back the underlying. If it rallies, we can sell the calls, hedge them, or take delivery of more NEM shares in August. I also own GDX, and when deciding between doing this for GDX or NEM, there were several considerations. GDX trades at a lower volatility because it is a portfolio, while NEM is a single name. GDX is closer to its local high, which means its risk is higher currently, and if it does achieve an upside breakout, it would likely see increased flows, which would also flow into NEM since it is a constituent of GDX. Any breakout from an existing trading range is a destabilizing event and tends to see implied volatility increase. This is why we say that risk increases when something trades near the boundaries of a trading range. First, it is a highly visible reference point that many investors focus on. Second, the risk is asymmetric because a breakout failure is a stabilizing event while a breakout is destabilizing. In the case of GDX, with the primary trend in GLD being higher and bullion in short supply, we'd shade the odds towards an upside breakout in GDX, which should drag NEM higher from the complementary flows, increasing volatility for both GDX and NEM. To be clear, this sort of analysis should never be the only reason to do a trade unless you are a pure speculator—it is only one of many potential outcomes but demonstrates the importance of understanding flow dynamics and spot-vol correlation dynamics. Bringing it all together, I am getting what look to be fairly priced August options which give me exposure to 1) a directional move higher and 2) upside volatility. It looks like fairly priced optionality to me with a shot clock that I don't mind because of the range dynamics at play. In other words, if NEM isn't above the strike by August, I probably don't want to be owning it anyway. Most importantly, this position gives me more choices than I had from just owning the underlying. I've got an open-ended straight draw after the flop, and I have many choices for how to play my hand depending on how things play out over the next six months. I don't trade a lot, and the hardest thing for me now is making sure I monitor this position and continue the decision-making process.