Investing and speculating in gold stocks is a very risky business. While they tend to greatly leverage the underlying gains in gold during a secular gold bull, individual stocks face a wide variety of perils on their journey to legendary gains. As a scary recent example illustrates, sometimes these perils can be catastrophic.

In late November, long-time junior-gold market-darling NovaGold (NG) shocked investors with a stunning announcement. This company said that its flagship Galore Creek project, which it only started construction on six months earlier, was suddenly uneconomical. NovaGold was shutting it down! As the markets opened after this news, NG gapped down 27%. It ended that single trading day down 53% from the previous day's close! Talk about a catastrophe for its owners.

Traditionally traders deal with this company-specific risk by being well-diversified. If you own a single gold stock, and something like this happens, it will crush your portfolio. But if you own ten or twenty of them, with capital allocated roughly equally among all, freak single-stock plunges will barely even make a dent in your overall portfolio. But prudent diversification often requires too much capital for small traders.

If you have $20k+ allocated to gold stocks, it isn't too difficult to own ten to twenty different positions. But as you scale down from here, relative commission costs balloon. A $10 trading commission on a $1000 stock trade is acceptable (1%). But that same flat $10 commission on a $100 stock trade is ridiculous (10%). So traders new to gold stocks with small capital allocations often have a very difficult time adequately diversifying away company-specific risk.

Thankfully exchange-traded funds offer a solution to this dilemma. Stock ETFs are baskets of many stocks that are traded through your ordinary stock-trading account with a single symbol. The most well-known stock ETF is the PowerShares QQQ, which is a basket of every individual stock in the NASDAQ 100 index. By simply buying the symbol QQQQ in one single trade, traders can indirectly own a stake in all 100 NASDAQ 100 stocks.

After years of waiting, we finally have a QQQ-equivalent in the gold-stock world. Administered by Van Eck Global, it is known as the Market Vectors Gold Miners ETF. It currently contains 34 component gold-mining and silver-mining companies. It trades under the symbol GDX. So by simply buying GDX, traders are granted instant sector diversification through indirect stakes in 34 gold and silver companies.

I have been closely watching this ETF since its May 2006 launch, observing how it performs and actively trading options on it. Always skeptical of new trading vehicles, I wanted to wait at least a year to see how it performed relative to headline gold-stock indexes like the HUI. Now, over a year and a half after launch, I am finally comfortable that GDX is doing exactly what it advertises. I have even become a fan of this ETF.

In this essay I want to explore the young GDX Gold Miners ETF, from its composition to its life-to-date performance. Investors and speculators alike need to be aware of GDX because it is such a wonderful trading tool. It not only grants instant intra-sector diversification at all capital levels, but it is growing into the ultimate way to trade stock options on gold and silver stocks as a sector.

In order to understand any ETF, we first have to consider its composition. GDX is based on a little-known index called the AMEX Gold Miners Index (GDM). GDX simply imitates GDM's internal structure in terms of weighting individual component companies. According to the American Stock Exchange, the GDM is "a modified market capitalization weighted index comprised of publicly traded companies involved primarily in the mining for gold and silver. The Index divisor was initially determined to yield a benchmark value of 500.00 at the close of trading on December 20, 2002."

In order to be eligible for inclusion in the GDM, a company must first meet three criteria. First it must have a market capitalization exceeding $100m, which eliminates the hyper-risky micro-cap stocks. Second it must have an average daily volume of at least 50k shares over the past six months, which means it is liquid and easy to trade. Third, it must be involved primarily in gold mining and/or silver mining.

Today GDM is trading in the 1250 range, so it has outperformed most other sectors since late 2002. GDM is a fine index, but curiously it has never really seemed to catch on. I have been actively trading gold stocks since this bull began in late 2000, along with doing much research and writing on them. Back in the early days, the XAU was the gold-stock index of choice. Gradually the HUI replaced it though due to the HUI's unhedged nature. GDM was almost never discussed.

This is even odder considering that the AMEX is not only the GDM custodian, but it administers the flagship HUI as well. Why would one exchange make two competing indexes for a single rather obscure sector? Perhaps someone from AMEX will be kind enough to write in and enlighten me, because I have no idea why both GDM and the HUI exist. If I get a solid answer, I will write about it in a future essay.

Regardless of the GDM and HUI mystery, the HUI has become the gold-stock index of choice for investors and speculators. The HUI is to gold stocks like the NASDAQ is to tech stocks. Its unhedged nature really appeals to traders burned by companies hedging their gold production earlier in this bull. Provocatively though, while the HUI is advertised as unhedged, AMEX's formal definition of "unhedged" probably differs from that of most investors.

The AMEX declares, "The HUI Index was designed to provide significant exposure to near term movements in gold prices by including companies that do not hedge their gold production beyond 1.5 years." So HUI components can still be lighter hedgers! Despite this, the HUI is still up 1167% bull-to-date since November 2000. This light-hedging revelation always provides good shock value for those who aren't yet aware of it.

Anyway, in order to compare GDX with the HUI, and also the XAU (which has no hedging restrictions), I built a table with the relative component weightings in each index as of this week. Each of the 34 component companies of the GDX is listed, followed by its market capitalization and relative weight by market cap. This provides a good benchmark off of which to consider the index weightings. While none of these indexes is truly market-cap weighted, they all approximate such a scheme reasonably well.

As you can see, the gold and silver miners remain pretty small in market-cap terms compared to the general stock markets. All 34 GDX components added together only had a market capitalization near $163b earlier this week. To get perspective, Google's market cap alone ran around $220b! And as of the end of last month, the entire S&P 500 had a market cap of $13,369b which utterly dwarfs the gold stocks.

Thus the gold-stock sector only weighs in at the equivalent of something like 1.2% of the broader US stock markets. This is one key reason why gold stocks will skyrocket when the public gets enamored with them. This sector is just too small to accept a flood of new capital. And as the HUI is already up nearly 1200% in its bull at this stage despite being totally ignored by the mainstreamers, imagine where it will go when the mainstream inevitably starts getting interested in chasing this stellar performance.

As is evident in this table, despite generally following a loose market-cap weighting scheme all three indexes have plenty of discrepancies. GDX, for example, gives Yamana Gold (AUY) a massive 8.4% weighting despite its 2.8% weight by pure market cap. The HUI currently assigns Northgate Minerals (NXG) a 4.7% weighting although it only comprises 0.5% of this sector as measured by the 34 GDX stocks. So realize that all of these indexes are just rough approximations of a true market-cap weighting.

Interestingly, all 15 HUI component companies are also included in the GDX. Together they account for 74.4% of the GDX. This percentage has actually been rising. Back in late June when I did a similar GDX/HUI analysis for our newsletter subscribers, all the HUI components only made up 70.3% of the GDX. With so much in common internally, for all intents and purposes GDX may as well be the HUI.

The XAU is not as well-represented in the GDX. Of its 16 components, 2 are not included in the GDX. The main one, Freeport-McMoRan (FCX), weighs in at a massive 20.7% of the XAU. While I love this company as a general commodities-stock investment, it is a primary copper miner, not gold. So I am glad it is no longer included in the HUI or the GDX. Overall the 14 XAU components included in the GDX represent 78.4% of the GDX's weightings (74.5% in late June). So the GDX is also a decent XAU proxy as well. But with FCX as the XAU's largest component, copper has a disproportionate impact on the XAU compared to the HUI and GDX.

Looking through the GDX component companies, the great majority are excellent gold and/or silver miners. Together they have countless mines, development projects, and exploration projects all over the world in almost all possible geopolitical and geographical environments. They are also well-diversified as evident by their weightings. If any one GDX company pulled a NovaGold and collapsed 50%+ overnight, it wouldn't materially hurt this index unless it was a top-three component. And even then, GDX would only take a 5% to 7% hit.

So from a pure internal standpoint, GDX is very closely related to the HUI. Yes the GDX has many more components and no the weightings among the common ones are not identical. Nevertheless, the similar modified-market-cap construction approach means the GDX is an excellent proxy for the headline HUI. Stock traders who want sector-wide exposure via a HUI-like index will be well-served by GDX.

In its initial year of existence concluding this past May, I received a fair amount of e-mails asking about the GDX. All I could say by that time regarding its utility though was "we'll have to wait and see". The only way to really understand how well GDX tracked the familiar HUI was to watch this ETF actually trade and compare it to the HUI. Finally today with 18+ months of history, including one major correction/consolidation and one young upleg, we have a solid technical basis off of which to render judgment.

Since its birth, GDX has carved a virtually identical price pattern with the flagship HUI gold-stock index. Indeed, if I removed the vertical axis labels and substituted one data series for the other, not even hardcore students of the markets could tell the difference. Overall the GDX and HUI had a stellar correlation r-square of 98.74%! This means that nearly 99% of the daily price action in the GDX could be explained statistically by the daily price action in the HUI.

I also wanted to look at actual GDX-versus-HUI gains and losses over big swings in the sector. These are marked above by the little blue arrowheads. From the June 2006 interim low until July 2007, the HUI rallied 35.6% compared to the GDX's 33.8%. During the gold-stock swoon this past July and August, the HUI fell 19.1% while the GDX fell 20.0%. In the young upleg since mid-August 2007, the HUI soared 51.9% while the GDX followed closely at 51.5%.

While these big-swing returns aren't identical, they are pretty darned close and plenty good for me. Actually, like all ETFs, GDX will slightly underperform its underlying assets by design. The reason is expenses. It takes a lot of time and effort to manage an ETF, so its custodian is granted a contractual management fee. In GDX's case, this runs 0.55% of assets annually. So every year GDX itself will be worth another 0.55% less than its underlying basket of stocks.

This disturbs some people, as I recently discussed while looking at the GLD gold ETF. But it shouldn't. Management fees, or expense ratios as they are called in the ETF world, are just the nature of this beast. ETFs really expand the horizon of what is possible for individual traders. For all their benefits, we need to expect some minor costs. For comparison, the elite QQQQ NASDAQ 100 ETF has an expense ratio of 0.2% annually while the GLD gold ETF runs 0.4%. GDX's is higher which makes sense because it is vastly smaller than either QQQQ or GLD, so its expenses are spread across a much smaller asset base.

Even after these necessary expenses, GDX still tracks the HUI extraordinarily well as this chart shows. This is all the more impressive because GDX isn't designed to track the HUI, but the GDM. Nevertheless, its HUI-like composition makes it an effective HUI tracker. Any investor or speculator can buy GDX and expect his capital to move in lockstep with the HUI and ultimately exhibit almost identical gains or losses.

Because of this inadvertent HUI parallelism, GDX is useful in many different ways for traders. For smaller pools of capital, GDX offers instant diversification among gold and silver stocks with a single trade. I often recommend GDX for this very purpose to my consulting clients who don't yet have $20k+ they are willing to allocate to gold stocks alone.

GDX is also useful for larger pools of capital. Sometimes capital is locked in a vehicle that either restricts trading or the number of individual positions held. The owner can buy GDX in a single trade and know he has instant diversified gold-stock exposure. GDX is also very valuable for people who don't have the time or knowledge to research individual gold stocks. They can deploy capital into GDX, own a basket of gold stocks, and they are good to go.

As a speculator, I find GDX the most exciting as an options vehicle. For years gold-stock traders lamented the fact that no stock options traded on the HUI. So in the past we had to resort to synthetic HUI options, trading an individual stock like Newmont Mining (NEM) that closely followed the HUI statistically. Although this was an acceptable workaround, it was really risky. Any surprise NEM-specific news could blow our options out of the water even if the HUI was conforming to our expectations.

But GDX not only follows the HUI nearly perfectly statistically, it is built much like the HUI internally. So any company-specific news on a component will barely be felt by GDX just like it would barely be felt by the HUI. Today a robust options market has sprung up around GDX. If you buy a GDX option today, it is effectively the same thing as buying a hypothetic HUI stock option. GDX options are a godsend for gold-stock options traders.

In addition to having good volume and liquid prices, GDX options are very granular. You can buy options with strike prices at every $1 of GDX's price, which is very nice to precisely tailor options trades to your expectations. Often individual gold stocks will have options strike prices spread out over every $2.50 or even $5 of a stock's price. This makes it difficult to buy at-the-money calls or puts. With nice tight $1 strikes, this issue is virtually nonexistent in GDX though.

With GDX now the ultimate gold-stock-sector options trading vehicle, and an avenue for instant sector diversification for those who can't afford the capital or research time to buy individual gold stocks, I am really impressed by this young ETF. GDX really makes gold-stock trading a lot more accessible for new traders. I really wish it would have launched earlier in this gold bull, as it would have saved us early traders a lot of angst.

For me personally, GDX is primarily a synthetic-HUI-options trading tool. GDX essentially is the HUI and trades as such. But in the markets, experienced and prudent traders can often handpick a better superior-performing group of stocks than any given index. If you are comfortable with individual stocks rather than baskets, you can custom build a tailor-made portfolio of elite gold and silver stocks that should handily outperform the GDX and the HUI.

Thus at Zeal we spend a great deal of time researching individual gold stocks to find our favorites with the highest potential to soar along with this gold bull. We just finished a deep research project looking into over 100 gold stocks worldwide. After four months and many hundreds of hours, we whittled them down to our 20 favorite gold-producing stocks. Our new fundamental report on these elite stocks is available today for a nominal fee. Buy it today and build your own custom portfolio of high-potential gold producers!

With so much irrational fear and pessimism swirling around gold stocks today despite the magnificent $800 gold, it feels like mid-August right before this sector soared. So if you want to buy GDX or individual gold stocks on the widespread fear that often marks major interim lows, today looks like a great time. The gold stocks will have to soar far higher before greed once again returns to this sector near the next major interim top. Take advantage of others' irrational fears to buy bargains today. To see which individual gold stocks we are buying now, subscribe to our acclaimed monthly newsletter.

The bottom line is GDX is a wonderful tool for gold-stock traders. It has finally been in existence long enough to prove its multi-faceted utility in the crucible of real-world markets. It provides instant diversification for small capital pools and those who cannot buy or are not interested in owning individual gold stocks. It has also grown into the ultimate gold-stock-sector options vehicle, a delight for speculators.

The GDX gold-stock ETF is composed like the headline HUI, trades like the HUI, and offers returns like the HUI. While it isn't designed to track the HUI explicitly, it may as well be. Traders who have long longed for a HUI proxy tradable in ordinary stock accounts can rejoice. Our wait is over. GDX has the potential to accelerate and revolutionize gold-stock trading much like the QQQs did for tech-stock trading.