The End of the Gold Story

Jun. 7.10 | About: SPDR Gold (GLD)

Brett Arends is out with the final installment of a three part Wall Street Journal series on everyone’s favorite metal these days – gold. A look at the first two parts are linked to below and, as should be clear from the titles, I didn’t think too much about part two:

The final chapter is titled Playing Gold without Getting Killed and, unfortunately, it really doesn’t add much to what has been an interesting discussion only insofar as it provides yet another window into mainstream thinking about the metal that has bested just about every other investment over the decade.

You can see signs of a gold rush everywhere, from nonstop TV commercials in the U.S. to the Emirates Palace Hotel in Abu Dhabi, where a vending machine dispenses gold coins.

If anything, the nine-year gold boom has intensified as traders nervous over the European financial crisis have flocked to the metal’s perceived safety. The assets in the SPDR Gold Trust , an exchange-traded fund that tracks the price of gold, jumped by more than 10% in May alone.

The question for investors who have remained on the sidelines until now is whether there still is an opportunity to join the stampede—and, if so, how to do it without getting crushed.

Gold prices have risen nearly fivefold since 2001. Yet, remarkably, some analysts say the rally might still have legs.

Gee. It’s not hard to guess what the real feelings are here.

Terms like “gold rush”, “gold boom”, “join the stampede”, “getting crushed”, and the telltale characterization of “remarkable” regarding the idea that prices might continue to rise from here, that is, beyond half of the inflation adjusted high from 30 years ago.

Phew! Contrarians are sighing in relief – the gold bull market is still intact.

Now, here’s why gold is probably a bubble about to burst and here’s how you play it – sound advice coming from someone who probably has never owned much of the metal (if any at all) all the way from $300 an ounce up to its current $1,200.

But the long gold rally also is stoking fears of a bubble. While that would augur for more gains in the short term, it also could set the stage for a crash later on. A similar pattern unfolded in the 1970s: gold rallied for most of the decade, peaking in 1980 at around $850 an ounce. Then it plummeted, bottoming out at around $250 in 2001.The lesson: gold can be dangerous, and its steep rise only makes it more so. John Hydeskov, senior currency analyst at Danske Bank in Copenhagen, warns that gold may be especially vulnerable to a short-term pullback now. Too much speculative money has already chased the futures market higher, he says.

That is why some investors are hoping to thread a needle, making bets they hope will pay off if prices go up, while limiting their losses if the market drops.

One way to do that is to buy call options on the GLD exchange-traded fund. Call options give you the right to buy the fund at a later date if prices rise further, while letting you walk away with only small losses if they tank.

So instead of risking $119 a share on the GLD fund, investors could, for example, pay $16 for $120 call options good until January 2012. That would give them the right to buy the shares at $120 if gold booms, and limit their losses to $16 if gold tanks. (These are per-share values. Options trade in lots of 100.)

The call-option strategy “is a way of buying exposure cheaply,” says Alan Lancz, a money manager for institutions and wealthy clients in Toledo, Ohio. He says it lets investors use “a small amount of money to get exposure even when prices are this high.”

“It’s one way to avoid losing incredible amounts of money,” adds Larry Glazer, portfolio manager for Mayflower Advisors in Boston. “At any given moment this thing could have a massive selloff.”

If you’re not scared out of your boots by now, go out and by a call option – maybe two.

This is actually kind of amusing. As wealthy investors around the world are out trading in their paper money in record amounts for something a little less likely to become worthless someday – causing the second scramble for physical metal in less than two years – The Wall Street Journal thinks that buying the metal is too risky and that its readers should buy $16 call options (i.e., one contract = $1,600) to satisfy any developing gold lust instead.