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Summary

  • Income investors generally avoid precious metals because these assets do not generate an income stream.
  • Investors who rely on dividend income should have 2 years of basic expenses in safe, highly liquid form to avoid the need to convert to cash in market shocks.
  • Today, I discuss how to use gold to protect against sudden market shocks and obtain superior monthly income while doing so.

With gold currently trading near its all in sustaining cost (AISC) to produce, there is now an opportunity for income investors to own gold for the dual purpose of maintaining 2 years of cash liquidity to hedge against sharp short term market crashes and to generate monthly cash income at the same time. This is an attractive strategic alternative to holding cash or short term monetary instruments which currently pay extremely low yields.

(image source: biostockspro.com)

Gold has traditionally been a safe haven asset to hedge against inflation, government instability, and disaster shocks where a readily liquid hard asset is advisable. Through the ages right up to the present time, people have held gold in various forms for this purpose. These include coins, jewelry, ingots, depositary receipts, and gold mines. With the exception of gold mine shares (and mutual funds of such shares) which may pay dividends, each of these forms share some negative traits:

  • Cost of storage and security.
  • Price spread between buying and selling.
  • Risk of physical loss through theft or natural disaster.
  • No current income yield while the gold is held.

All of these elements combine to make holding physical gold a wasting asset with maintenance expenses and lost opportunity costs of non-performing assets slowly eating away at their value. For each and all of these reasons, gold has not been attractive as an asset class to income investors.

When picking an asset to place near term defensive living expenses (2 years of basic needs) cash or demand savings, short term bonds, and time deposits with an interest yield have been the traditional choice for the income investor. The ultra low yield environment persisting since the global financial crisis of 2009 continues to make these investment classes painfully poor options for income investors.

Several factors are currently present that offer the income investor a new alternative to the traditional ultra low yield choices for their liquid cash reserve. The sustained pullback of gold, currently at a New York spot price of $1293.00, to near the average AISC production costs for the major gold producers which is now exceeding $1200 per troy ounce sets the likely long term floor on gold and makes sustained departures below these AISC prices unlikely.

Erwin Lubbers observes in his recent analysis of gold price trends at goldresearcher.com:

Rising costs should put a downside protection or floor on the gold price. When the cash cost is higher than the gold price, mining companies will attempt to halt production at those mines until the gold price increases. In the first half of 2013, the gold price hit a low of $1190, a price level below the All in Sustaining Cost of many gold miners. The gold price recovered to above $1300 a few weeks later, a level just above profitability.

This current threshold pricing of Gold suggests a strategy of using SPDR Gold Shares (NYSEARCA:GLD) (an ETF of gold depositary receipts) as a suitable risk asset to use for short term defensive cash instead of actual cash, bank deposits, or short term bonds. Buying the GLD shares and concurrently selling at the money near term covered call contracts on those holdings generates an attractive yield rate at this time while maintaining the defensive cash liquidity desired in the case of market shocks.

Because gold prices are expected to be more stable than equities and bonds, or even rise in times of global crisis, disaster, or inflation, the units will likely be called away from you if such events arise. The effect is to convert your gold holdings back into the cash asset you would be holding if you had not shifted from the liquid cash investment into the gold units. However, unlike holding the cash or low yield deposits, you are earning a much more attractive yield on the covered call option premiums you receive in using this strategy.

There is added downside risk to capital preservation with this strategy because you are exposed to the fluctuating market price of gold. However, the downside risk is sharply reduced during periods of market crisis when gold is expected to rise. Thus, your risk is least when the likelihood of call away conversion and your desire to shift back to cash is highest. This is a good tradeoff in the current market price environment.

The GLD ETF avoids the negative features of holding gold cited above except for some of the storage cost features. The GLD manager sells off a small amount of the total gold reserves each year to cover storage and management costs. This generally is about 0.4%.

A current example of employing this strategy is to allocate a defensive 2 years of bare minimum cost of living expense to buying gold. We will use $60,000 in this example. GLD closed Friday May 23, 2014 at the time this article was written at $124.51. Therefore, $60,000/$124.51 = 481.89 units of GLD. We round up to 500 units in 100 share lots so as to have round lots to write our covered calls with. $124.51 * 500 = $62,255. At the same time, the Friday afternoon trading price for 6/21/2014 $125.00 calls was $1.53 premium for the standard 100 share contracts and $1.31 bid on the premium on the 10 share GLD7 mini options. The sale of 5 call contracts of the standard GLD 100 share lot options generates $153 * 5 = $765.00 cash income for the 27 day contract. This is an absolute yield of 1.23% and an annualized rate of return on our invested funds of [(1.23%/27 days)*365] = 16.63%, a much higher yield rate than available from any deposit savings, money market, or similar risk level bond.

This example shows how moving our defensive cash reserve into gold currently adds to monthly income for investors who follow a dividend income investment strategy. It does so while managing risk through a strategy anticipating call away in up-trending markets of either normal trend or, even more importantly, those triggered by market crises. Each month a new covered call contract is written at the $125 strike, if the shares have not been called away. If they have been called away in the absence of a broader market shock, then a new long GLD position is bought for the round lot $60,00+/- position and covered call contracts at the money are sold anew. This way, the 2-year defensive cash is maintained at its same general level regardless of the upward trending price of gold.

There is a very important limiting caveat for this strategy when used by dividend income investors. The downside risk is only manageable and acceptable when the price of gold is near its AISC of production. If and when gold moves significantly above that price point, the downside risk of a sharp and sustained fall in gold prices due to a deflating bubble becomes too great of a risk to expose defensive cash reserves to.

Options trading is always best done inside a tax preference account (IRA, ROTH, SIMPLE, etc.). Tax consequences of call-aways should always be considered when selecting appropriate Strike prices and contract lengths.

In addition to the current threshold pricing of gold near its AISC production price, the current global political crises; Chinese economic weakness and Renminbi currency instability; and potential re-emergence of eurozone issues with Greek, Spanish, Portuguese, and Irish debt; make gold likely to further limited downside risk to current gold pricing.

I hope you will have an interest in my recent series and current new series where I detail the use of covered option writing to boost yields on quality dividend income equities. Simply click on the bold link labeled FOLLOW above the title at the top of this article to get an email notice of my new articles when they are published. You will need to be sure that in your account SETTINGS/EMAIL ALERTS/DAILY EMAILS that you have checked the AUTHOR ALERTS box. Click here for a link to the index of my past and future articles.

I am not a licensed securities dealer or advisor. The views here are solely my own and should not be considered or used for investment advice. As always, individuals should determine the suitability for their own situation and perform their own due diligence before making any investment.

Disclosure: I am long GLD. 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. I am also short the 6/21/2014 $125 covered calls as described in the article strategy.

Source: Buy Gold Now? What Every Income Investor Needs To Know