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Funny things have been going on in markets for some time now. Stocks, corporate bonds, commodities, and currencies were decimated in 2008, with the volatility threatening to persist into the New Year. There’s talk of deflation, inflation, stagflation, defaults, bankruptcies, layoffs, unemployment, and the best word of the year: de-leveraging. Wait, is that even a word?

The only thing we know is that we don’t really know what’s happening or where it’ll take us. The more confused people become the more gold they buy. In fact, from peak to trough gold (GLD) has risen 52% over the last 52 weeks. With this kind of bull run, it makes sense to lodge a small bet in the other direction.

This rise has been sharp. Over the last three months GLD is up 27%:

click to enlarge

Gold is the only currency that has proven it can withstand the ravages of time and public officials. According to Bill Bonner and Addison Wiggin in Empire of Debt:

A gold denarius is still about as valuable as it was when Caesar conquered Gaul.

Contrast that with the US dollar, which has lost 95% of its purchasing power since the Federal Reserve was created in 1913.

With $12 trillion in public debt, $50 trillion to $70 trillion in unfunded liabilities for Social Security, Medicare, and Medicaid, $8.5 trillion in new money created in 2008, and a $2 trillion budget deficit in 2009, it should leave us all with a sense of bewilderment. Is our government falling down the same trap as every other that has issued paper currency in history? Or is this fancy, high stakes game of financial craps going to work out and leave us all better off in the end?

The gold market is starting to bet against the politicians and bureaucrats. My guess is that it will continue to do so and gold may soar to parity with the Dow Jones Industrial Average. That’s simply my guess, of course, but my portfolio rests firmly on that thesis. I don’t buy the elaborate arguments with big words and complicated phrases like “quantitative easing,” “reserve currency,” and “velocity of money.” In my simple mind, if you expand the money supply while productive output declines you debase the currency. When paper currencies go, gold gets going.

Nonetheless, with all the emotional opinions on both sides of the argument, playing the gold market is becoming increasingly risky. Regardless of which side you play, it is worth buying insurance in case you’re wrong. Personally, I have begun hedging my gold bets with long term (January 2011) put options on GLD. I bought them significantly out-of-the-money (OTM) to act as nothing more than catastrophe insurance.

There are a few other ways to hedge gold:

  • UltraShort Gold ProShares (GLL)
  • Buy puts / sell calls on GLD or GDX
  • Sell futures (ZG or YG) or trade futures options

With only $23 million in net assets, I’m not a fan of GLL; however, a quick look at its pricing chart shows that it does a decent job mimicking the double inverse of GLD.

GDX is a composite index of gold miners, so its price has dependency to equity markets. If inflation kicks in it could boost nominal equity prices and GDX could benefit from both gold and equity gains. Deflation and falling gold prices could have the reciprocal effect.

Futures options for gold contracts present a rather illiquid market, unfortunately. Best to stick with GLD put options if you want to hedge gold prices. You could sell calls, but then again, if you’re right it would be a shame to limit your upside.

Disclosure: long GLD, long GDX, short GLL

Source: Now's a Great Time to Hedge Your Gold Bets