Why Freeport Could See More Pain Ahead

Gold bars and coins
Chris Ratcliffe | Bloomberg | Getty Images

A big story for the markets is the crash in gold prices following Friday's 4 percent plunge. Gold continues to rip through levels of support like they are non-existent, suggesting investors are running for the exits no matter what the price. The sell-off in gold has dragged the gold miners down with it, including Freeport-McMoran.

This stock is down 12.5 percent from last week's high, and off over eight percent as of Monday afternoon. But option traders are continuing to make bearish bets on the stock, which suggests that the bottom may not be in yet for gold or the gold miners.

One of the biggest trades today in Freeport-McMoran was the purchase of 3,215 August 21-strike puts, and the sale of 3,125 August 27-strike calls, for a total net credit of $3.82. This position is known as a "risk reversal," and is very similar to a short stock position.

These option spreads are typically done against a long-term buy-and-hold stock position to flatten exposure without creating a tax event. This spread, when done against a long stock position, will cap losses below $21, but will also cap gains in the stock above $27 between now and August.

This trader must believe that the next four months will be rough for gold and the gold miners. We would tend to agree with this thesis, and are reducing our risk and exposure to precious metals and commodities as a result. What we believe we are seeing is that traders are using the Cyprus situation and poor data out of China to take profits in gold positions they have had on for years.

Many initially bought gold as an inflation hedge when quantitative easing started. But now that we are beginning to discuss the end of QE, and there is still no inflation, traders are either taking off their inflationary positions or even putting on deflationary trades. Additionally, the prospect of higher interest rates in the future has led investors to reevaluate whether they would rather own gold, which pays no interest and costs money to store, or U.S. equities, which pay dividends and have been appreciating in value.

We continue to want to own gold, but are capping our risk so that we do not join the panic selling we are seeing. We expect the next few days to be especially volatile in the gold markets, and covering risk keeps you unemotional during these times.

Although the economic models will tell you that inflation could still be a possibility due to a low interest rate environment and monetary base expansion, the volatility in gold alone tells me to limit risk. I still have a net bull position in the Gold ETF, but I have used options to begin to trade around my position through put spreads and short calls.

Brian Stutland is Managing Member of Stutland Equities and a contributor to CNBC's "Options Action."

Disclosures: Stutland is long GLD, and is long put spreads and short calls.

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