Yields Of 5.3%-23.2%: How Investors Can Turn Gold Into Even More Gold

| About: Credit Suisse (GLDI)

Editorial Note: This article continues my recent series of articles on hunting for yield in overlooked corners of a yield-poor market. See my previous articles about high yielding opportunities here, here, and here.

I like gold and I think most people do. The idea of physical money, be it cash or gold coins, just has a certain appeal to it - plus let's face it, printing out an electronic bank statement with your balance on it just lacks the same appeal as having a fistful of cash. The problem with gold (and most commodities for that matter) as an investment though is that it doesn't produce any dividends, and a lump of gold doesn't get any bigger over time. So instead, when an investor buys gold, they are basically hoping that the price will go up because of increased demand or decreased supply. It's simple speculation - which is OK - except that it's not appealing to a lot of investors.

In fact there isn't even much evidence that gold is a good hedge against inflation. Actually, it's kind of a lousy hedge against inflation. (A defense of this assertion is beyond the scope of this article, but see my articles here and here for more details.)

Gold's price seems to be driven largely by two factors: discretionary income for the average consumer and the amount of fear in the markets in general. Historically, gold and to a lesser extent silver and the gold miners have displayed a strong negative correlation with the rest of the market. On some of the worst days in 2008, virtually the only S&P 500 companies in the green were the gold miners. This negative correlation between gold/gold miners and the rest of the market was extremely valuable for investors because it enabled them to easily hedge their portfolio without having to take on short positions. The correlation coefficient between the gold miners and the broader stock market over the last 5 years is -0.68. This just reinforces the casual observation that when the markets are down, gold and the miners are up. In the last 6-12 months, miners and gold in general have been performing abysmally. Unfortunately for gold investors, this trend looks likely to continue. With the Dow and S&P hitting new highs every week, it's tough to come up with a fear based justification for gold to be trading higher than it is right now. However, for investors willing to wait the market out and who have faith that eventually gold's price will soldier higher, there is an alternative that I explain below.

There may be some justification for this view. Gold has been seen as a viable alternative to stocks for more than a decade now, in part because for at least 20 years, gold has basically kept up with the stock market in terms of price appreciation. The fact that a gold bar is a non-productive asset, and that firms are supposed to grow in size and profitability, lead the comparability of returns between the two groups to be as much an indictment of stocks as an endorsement of gold. For example, from December 1999 to mid-2012, gold returned an average of 15.4% annually vs. 1.5% for stocks and 6.4% for US bonds.

Investor perceptions about the value of gold differ sharply though. For example, Warren Buffett says that the recent run up in gold prices is similar to the Dutch Tulip Bubble, the Dotcom Bubble, and the Housing Bubble. As he explained in a recent letter to Berkshire Hathaway (NYSE:BRK.B) shareholders:

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth - for a while." Berkshire Hathaway 2011 Shareholder Letter, p. 18.

Taking the opposite view is Ray Dalio the founder of the world's largest hedge fund.

Gold is a very under-owned asset, even though gold has become much more popular. If you ask any central bank, any sovereign wealth fund, any individual what percentage of their portfolio is in gold in relationship to financial assets, you'll find it to be a very small percentage. It's an imprudently small percentage, particularly at a time when we're losing a currency regime. - Interview with Barron's, 2011

So clearly, the future of gold and its value from a fundamental standpoint is in dispute. But if you're an investor who believes in the future of gold, it's important to be able to generate some return while waiting for the market to come around to your viewpoint.

But recently, I was doing some research for an unrelated project and it occurred to me that gold does not have to be an income-less asset. You don't need to buy mining stocks like (NYSE:ABX), (NYSE:NEM), (NYSE:AUY), or even suppliers to miners like (NYSE:CAT), (NYSE:JOY), (NYSE:CMI), and (NYSE:MSA).

Instead, you can actually make money on gold itself. Specifically, you can use covered options positions to turn your stable lump of gold into a persistent stream of income and in turn earn yields of anywhere from 5.3% - 23.2% (based on data from current call option prices) depending on how much risk you want to take. This is likely to be a good time for this type of strategy given that gold's price has fallen markedly in the last few months so few people would call it a bubble right now (It may or may not be undervalued - that's again the subject of another article of mine here.)

To begin with, all of the data I use in this article is based on the price of the Gold ETF (NYSEARCA:GLD) and its associated options. The yields I calculate are based on holding GLD and selling call options, but you could also hold the physical metal and sell call options. That would increase your transaction costs and subject you to some margin requirements, but you wouldn't actually be taking any more investment risk than you do by holding the ETF.

So let's start with the basics of call options and how you can use them to generate income here. Just like with call options on stock, selling the call options on GLD gives you an upfront lump of cash (the premium) in exchange for the obligation to sell the buyer of the call GLD at a certain price (strike price). This obligation only lasts for a certain period of time (expiration or maturity date) however.

So I might sell GLD calls at a strike price of $140 with an expiration date of July 20th, 2013 in exchange for a premium of $5. What this would mean is that I have to be willing to sell 100 shares of GLD to the call buyer anytime between now and the third week in July for $140. In exchange, I get $5 that is mine to keep regardless of whether or not the call buyer decides he wants to buy GLD from me. In this case, if I bought some GLD at $140 and I am going to hold it anyway, then I have essentially just secured a $5 "dividend" for the next ~3 months. Annualizing this would give me a yield of about 14%.

Now of course, if the call buyer decides he wants to buy my GLD (i.e. if the price goes above $140), then I have to sell it to him. But if I bought the GLD for $140 or less, then this is not a big problem. I haven't lost any money on the sale.

What many investors who might be familiar with calls perhaps don't realize is that they are available on gold ETFs and they have numerous expiration dates. (More than I have seen on any other stock or ETF actually.) GLD has call expirations every week for a month or so from the current date, they also have monthly and quarterly call expirations for many months in the future. As a result, if you are concerned about having to sell a call few months and incur the transactions costs, you can simply sell a one-year call (roughly) expiring in June 2014, and collect about a 5.3% yield for your troubles (with about 2% of upside price appreciation built into the strike price).

If you are willing to do the work of selling a call every month or even every week, you can collect a little under 2% for selling a one month call which will give you an annualized return of 23.2%. Not too bad if you're a long-term investor who is willing to buy gold anytime its price falls and let other people buy it from you when it rises.

For those who like the idea of this strategy, but don't want to hold gold itself or go through the work of selling calls, an ETF (NASDAQ:GLDI) focusing on this strategy was launched earlier this year, and it's yielding around 9% annually right now after the 0.65% management fee.

The graph below shows the approximate return over the last few years from following the strategy I described above. Gold's price is shown in yellow, while the combination of gold and gold calls is shown in blue (includes cost of re-buying gold after price spikes cause GLD to be called away).

What the graph shows is that while gold has exceptionally good returns in the last few years, the price has still been highly volatile. In contrast, the strategy of buying gold and selling calls on it has led to a much more consistent and less volatile set of returns with an average annual return of about 15%.

In summary, while this type of investing certainly isn't for everyone, if you're interested in investing in gold, but you don't like the volatility or the lack of regular income, then selling periodic call options (especially long-term call options) can be an attractive alternative.

For more details on this and regular updates on the performance of this strategy, see my blog here.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.