What to Do About 'What-If' Gold? 31 comments
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The diverse array of experts interviewed by Hard Assets Investor (HAI, HardAssetsInvestor.com), together with our opinion pieces, is virtually guaranteed to perturb some of our readers while pleasing others. And no single subject causes more fur to fly than gold.
In particular, prognostications for gold prices seem to stir up a lot of emotions, and at any given time, gold bears get the worst of it from readers. Yet there are times when a sell-off ought to be reasonably expected or even welcomed. Sometimes, a commentator or interviewee merely espouses a bearish gold view as a counterpoint within a balanced examination of the market.
Consider our recent take on the prospects for inflation ("Laying Odds On Inflation"). Through trend analysis, we attempted to put numbers to the predictions for runaway inflation as well as for a deflationary spiral.
Arguments for an inflationary setup abound, but the deflationary scenario often gets short shrift. In the article, we calculated the chances of a rather modest one-standard-deviation decline in monetary inflation - or seeing the index drop from the 152 level to 136 - sometime within the next 500 days at 43%. Two-for-five odds - not an insubstantial probability.
In such a situation, the accompanying decline in gold's price could be significant, since our measure of monetary inflation is, in large part, based upon the dollar's gold purchasing power. Such a decline in fact, is anticipated by some chart watchers who've been looking at gold's recent trading pattern and see the potential for a big breakdown.
How big?
The Case For Lower Gold
Well, consider that the spot COMEX contract closed atop $1,001 in February, only to slide to the $867 level in April. Attempts to make new highs have twice failed, leading the technically minded to think that a breakthrough move below April's low could ensue, as a setup for a test at $733.
There are, as well, fundamental arguments for lower gold prices, such as those discussed in our May interview with Heraeus Precious Metals Management Vice President Miguel Perez-Santalla. He called for a short-term sell-off, saying, "I could see gold in December coming down to around $700."
A sell-off wouldn't necessarily inflict fatal damage to gold's long-term trend. If anything, it might even be considered healthy, since it would drive fresh buying from the key jewelry segment, according to Perez-Santalla. A decline to $805 in the spot COMEX contract would retrace about two-thirds of gold's November-February run-up, which could be a good place for a rally.
Failure there, however, could inspire aggressive technical selling. After all, the base for the fall 2008 rally was $681, perilously close to Perez-Santalla's $700 objective. Downside excursions testing the base could very well inflame bearish sentiment.
In particular, traders who view the last 16 months of gold market action as a consolidation top see a downside objective of $357 - a level not traded since 2003 - for the nearby COMEX contract, should the 2008 base be breached.
Present-day fundamentals may not seem to sync with such a drastic sell-off, but we know from past experience that fundamentals often take a back seat in the gold market, at least for a time.
Protecting Your Gold With LEAPS
So ... what if? What if a big break in gold does materialize? What insurance can protect you if you've been building a gold hoard?
Enter LEAPS-or Long-Term Equity AnticiPation Securities - on the SPDR Gold Shares Trust (NYSE Arca: GLD). LEAPS, most particularly LEAPS puts, are long-dated options that can provide a form of term insurance for a gold stash. (Puts give their owners the right - but not the obligation - to sell the contract's underlying asset at a fixed price until its expiration date.)
Ordinary GLD options are short-lived. Accordingly, most traders are interested in the options expiring within the next calendar quarter: contracts that terminate in August, September or October, for example. LEAPS, however, go out nearly two years.
To better understand how LEAPS work, let's look at an example: the January 2011 puts. You could buy a put that entitles you to sell GLD shares at $70 through January 2011, no matter how low (or high) they actually trade in the open market. GLD at $40? No problem. You can sell your GLD shares at $70 through the exercise of your put. GLD at $30? Still not a problem. You're good at $70.
Oh? Don't have any GLD shares to sell? Well, that's not a problem, either. Just sell your option. Its market value will vary, to one degree or another, with the value of its underlying shares and the time remaining ‘til its expiration.
With GLD presently trading around $92, you can buy a put entitling you to sell GLD at $70 for about $2.60 a share. Since an option conveys rights to a round-lot of 100 shares, the total cost for more than 500 days of insurance is just $260. So if GLD drops to $40 during the LEAPS' life span, your put ought to be worth at least $30 a share (or the selling advantage represented by exercising the option at $70, when the shares' market price is $40).
Using LEAPS As Insurance
GLD tracks the price of gold bullion, so you'd expect COMEX-analogous patterns on its price chart. And just like bullion and COMEX gold, GLD's price trajectory has stalled this year. GLD's $31 consolidation range suggests a downside objective of $38 a share if gold drops to the $357 level.
SPDR (Formerly streetTracks) Gold Shares Trust
Should it do so, that's when the catastrophic insurance capability of the LEAPS put would kick in. Suppose, for example, you held 100 ounces of bullion. Presently, your stash would be worth somewhere around $94,500 (assuming the bid for bullion is $945 an ounce). Let's also suppose you set a risk budget of about 25% of gold's present value as a defensible position; in other words, you'll stick with gold as long as you're not losing more than 25% of your investment.
You could hedge is by purchasing 15 of the January 2011 GLD $70 puts at $2.60 a share. Your insurance would cost about $3,900 ($2.60/shares x 100 shares x 15 contracts) in premium and would be likely to produce end-of-contract results similar to those shown below:
GLD Put-Hedged Bullion Projection - January 2011
Gold Price | Profit/(Loss) On Gold | GLD Share Price | Profit/(Loss) On GLD $70 Puts | Net Profit/(Loss) |
$1,245 | $30,000 | $121 | ($3,900) | $26,100 |
$1,145 | $20,000 | $111 | ($3,900) | $16,100 |
$1,045 | $10,000 | $102 | ($3,900) | $6,100 |
$945 | 0 | $92 | ($3,900) | ($3,900) |
$845 | ($10,000) | $82 | ($3,900) | ($13,900) |
$745 | ($20,000) | $73 | ($3,900) | ($23,900) |
$645 | ($30,000) | $63 | $6,600 | ($23,400) |
$545 | ($40,000) | $54 | $20,100 | ($19,900) |
$445 | ($50,000) | $44 | $35,100 | ($14,900) |
$345 | ($60,000) | $35 | $48,600 | ($11,400) |
In this scenario, your risk would max out at your budgeted amount should bullion dip to $745. At that price, you'd absorb a $20,000 loss ($200/ounce x 100 ounces) on your bullion and a total loss on the out-of-the-money put. The resulting net loss of $23,900 is 25% of your $94,500 bullion cost base.
It's important to keep in mind that as an option purchaser, you can only lose the contract premium and no more, no matter how badly the underlying market performs. Think of it this way: If you were a speculative GLD put buyer, you'd actually want the gold market to decline, so that your puts move into the money. That is, you'd want to be able, through the exercise of your options, to sell the underlying shares for more than their market price. The return on the puts is open-ended in a falling market.
Note also the impact of higher gold prices on your hedged position. At $1,245 an ounce, the puts are worthless, but your loss is limited to the $3,900 premium. That means the upside potential for hedged bullion is unlimited: It's only $3,900 less than unhedged gold. At the same time, there's a floor on the losses you can sustain during the option tenure; the open-ended gains obtained from the puts in a falling market eat up your bullion's quickening losses.
There's something else you should know about these GLD puts: You're not the only one who knows about them. At last look, open interest in the January 2011 $70 puts stood at 7,669 contracts. And if you thought a $70 exercise price seems overly pessimistic, consider this: The open interest in the January 2011 $50 puts is now approaching 33,000 contracts.
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The only scenario I see this happening is if the 'Green Shoots' turn into a lush forest of towering red woods AND the world see no risk for decades to come, AND gold is no longer a store of value.
Had you read the article's second half, you would have seen an illustration of the utility of GLD puts in protecting a gold hoard with a high cost basis. The full article can be viewed at www.hardassetsinvestor....
If you read the "Laying Odds On Inflation" article referenced in the piece, you'd see 60-40 odds laid for an UPWARD spike in the monetary inflation index. Since we can't know the future with perfect certainty, having a hedge strategy in mind in case of a downturn is just prudent policy.
On Jul 24 04:18 PM MikeTojo wrote:
> Why could possibly make this article an editor's choice?
>
> The only scenario I see this happening is if the 'Green Shoots' turn
> into a lush forest of towering red woods AND the world see no risk
> for decades to come, AND gold is no longer a store of value.
On Jul 25 06:51 AM Freya wrote:
> If the USD does a number to the downside,
>
> www.bloomberg.com/apps...;sid=aOAiAnAtFdxA
>
>
> as the above link suggests, "All of the King's soldiers and All of
> the King's men, won't be able to put Humpty back together again."
There is always a delay of roughly 1 to 2 years (nominal 18 months) between the pumping and the price rise. Initially it looks like a demand signal. Business responds accordingly. Then the paper starts hitting the fan.
It is also my estimation that we have a stupider than average (economically) Congress. What could possibly go wrong?
Well, I could be wildly in error (won't be the first time), but those are my thoughts on the prospects of inflation.
This of course means its headed down. I believe in the short term it will do nothing.
Buy equities they have much more upside then gold which may not move for 25 years again.
chatter. My money is on gold and silver and LEAPS on miners.
Some people who cannot afford gold should also invest in Silver, it moves in correlation to gold and I plan on cashing in on both as the dollar falls.
Non-credit money is the necessary additional quantity of money in circulation (dM) as percentage (k) of existing quantity of money in circulation (M). dM = kM ; k = (supply - demand)/demand ;
If non-credit money is emitted according to the cited formula, inflation cannot exist. Also, taxes are annulled for the amount of non-credit money. The consumers pay less and producers get more than today, in the order of credit money. All get the gift from non-credit money. Non-credit money can solve the world economic crisis. Without gold. Without inflation.
It's bad out there, and scary to..... NOT.
> Given that gold is only priced at roughly 1/3 of any sort of current
> "equilibrium" price, and given that demand grossly exceeds production,
> your analysis lacks any credibility.
>
> There simply are no RATIONAL scenarios where gold goes significantly
> lower. As for your "deflation scenario", perhaps you need a reminder
> that the U.S. only accounts for 5% of global population, and that
> the global economy is now driven by Asia - where there is ONLY inflation
> on the horizon.