As The Herd Shakes Out, Downside Protection On Gold ETF Remains Inexpensive

| About: SPDR Gold (GLD)

Shaking Out The Herd

In a Slope of Hope post on Tuesday ("30.2 Yield Curve And Gold"), Gary Tanashian noted that, "over the last 1.5+ years gold has shaken out the herd" (Tanashian went on to predict that those who abandoned gold for "risk assets" would regret doing so). Hedge fund manager Tim Knight, not one to follow herds, reminded his readers on Tuesday that he's currently long gold via the SPDR Gold Trust ETF (NYSEARCA:GLD) ("Target on GLD Long Approaching"). Nevertheless, according to Reuters, more GLD herd members did get shaken out last month, with the gold ETF seeing a billion dollars in outflows in January. In this post, we'll look at a couple of updated hedges for GLD, which remains inexpensive to insure, despite its recent outflows. First, though, a note about Bernanke's testimony yesterday, and an interesting gold chart Bespoke Investment Group posted in response to it.

Gold And Bernanke

Possibly the most widely-quoted part of Federal Reserve Chairman Ben Bernanke's Senate testimony on Tuesday was this exchange between the Fed Chair and Senator Bob Corker of Tennessee, in which Sen. Corker called Bernanke an inflation dove, and Bernanke retorted that inflation probably has been lower during his chairmanship than any other time in the post-war period, averaging about 2% annually (I wrote "probably" there because Bernanke hedged his statement a little).

In response, Bespoke Investment Group posted the chart below, showing the performance of gold under the last four Fed Chairmen.

Bespoke Investment Group concluded,

For those who use gold as a gauge of the dollar's true purchasing power, Bernanke's statement doesn't hold much weight.

Eliding Secular Markets In Gold

Bespoke Investment Group's conclusion is true, as far as it goes, but it elides the secular bull and bear market trends in gold over the time frame of its chart. Of course, a secular bull market in gold peaked in 1980, and the next secular gold bull market didn't start until about 22 years later. Volcker's chairmanship includes the final run-up to the 1980 peak, and Greenspan's chairmanship includes most of the secular bear market in gold; someone who looked at Bespoke Investment Group's chart without knowing any of that might be misguided into thinking that Greenspan was an inflation hawk and Volcker a dove.

Downside Protection On GLD Still Cheap

Gold and the GLD, the most widely-traded gold ETF, both rose on Tuesday as Bernanke testified, with GLD closing up 1.2% on the day. Nevertheless, GLD is down about 10% from its 52-week high, and it's down nearly 15% from its all-time peak in September, 2011. Despite that, and despite GLD's recent outflows, the ETF is still quite cheap to hedge.

Why Consider Hedging If You Own Gold

Being hedged means not having to rush for the exits

If you own gold, whether via GLD, the iShares Gold Trust ETF (NYSEARCA:IAU), or via another gold ETF or via gold itself, and you're hedged, you can be confident that your downside in the face of a major correction will be limited.

1980 vs. 2008

If you're hedged when the next leg down in gold hits, you'll have the breathing room to consider whether that correction is analogous to 1980's crash from gold's secular bull market peak or to 2008's sharp, though temporary, correction.

Remember that in 2008 gold fell to a low of $712.50 per ounce, after having peaked at over $1,011 per ounce earlier in the year. A gold investor who had been hedged could have, if he were still bullish on gold at that point, sold his hedges and used the proceeds to increase his position in gold.

Two Ways To Hedge GLD

Below, we'll look at two different ways of hedging GLD against a greater-than-15% decline. The first way uses optimal puts*; this way has a small cost, but allows uncapped upside. These are the optimal puts, as of Tuesday's close, for an investor looking to hedge 1000 shares of GLD against a greater-than-15% drop between now and September 29th:

As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position value, is 0.62%. Note that, to be conservative, cost here was calculated using the ask price of the optimal puts; in practice an investor can often buy puts for a lower price (i.e., some price between the bid and the ask).

A GLD investor interested in hedging against the same, greater-than-15% decline between now and September 29th, but also willing to cap his potential upside at 15% over that time frame, could use the optimal collar** below to hedge instead.

As you can see at the bottom of the screen capture above, the net cost of this optimal collar is negative -- meaning the GLD investor would be getting paid to hedge in this case.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University.

The screen captures above come from the latest build of the soon-to-come 2.0 version of the Portfolio Armor iOS app. Optimal collar capability will be available as an in-app subscription in the 2.0 version of the app.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.