Reducing the Risk of Gold Exposure in a Portfolio Through Options

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 |  Includes: GDX, GLD
by: Common Cents

There are many opinions on the direction of the price of gold. Some believe gold is in a bubble and will be below $1000 soon. Others think gold is the only true store of value and will be surging past $1500 in the not too distant future. There is of course no sure way to know which of these scenarios will come to pass. There is however, a lot of solid analysis that indicates having a long gold position in a portfolio is a good diversification strategy. (i.e. hopefully if equities and bonds pull back, gold will not)

If you believe in the positive diversification aspects of having gold in a portfolio, there are a few basic alternatives to gain gold exposure in your portfolio. Buying an etf such as GLD is an easy way to do that. Alternatively, there might be some merit in achieving this exposure via gold mining stocks such as the GDX etf. Either might work. However, options on these equities provide another approach to gaining exposure which might minimize the risk in the event of a fall in the price of gold.

There are two factors that are the basis for the options strategy described below.

  • That GLD and GDX will be highly correlated. A three year correlation, found on the web, indicated a .96, correlation over 3 years. The strategy below assumes a correlation of 1. As actually correlation varies from 1 it will impact the results (to either the plus or minus).

  • GDX has a higher historic and implied volatility than GLD. This is probably because GDX not only has the risk of fluctuations in gold price, but also company and stock market risks. However, a common sense interpretation of a high correlation with higher volatility is that both equities will get to near the same point but one ride will be bumpier. I also means GDX options are more expensive than GLD old. Hence, there is an options pricing advantage to buying the cheaper GLD options and selling the more expensive GDX options.

An options strategy using these assumptions would be to establish a conceptual risk reversal trade on GLD and GDX in June options. June was chosen because it is far enough out to increase the likelihood of some event internationally, from Washington, from Wall Street etc causing a spike in gold price. Yet is not so far out in time to be overly expensive or risky. It also might take advantage of any seasonality in the price of gold.

The trade is to sell two June GDX ATM puts. Specifically a strike of $56 for $4 with an implied volatility of 31. Take half the $8 in cash and buy 1 June GLD $137 calls for $4 (implied vol 19). A one lot position will require $10,800 in risk capital (i.e. $56 strike*200shares - $400 net credit).

Lets look at a few scenarios.

GLD and GDX goes down from here.

Lets examine the worse case first. If gold falls, the GLD option will expire worthless and it is almost certain that GDX will stay below the $56 strike price. In essence the portfolio will be long GDX at $54. However, if gold falls far enough, this support will fail. For example if gold falls 10% and GDX get near $50. The position's value would be $10,000 an 8% loss. If the price plunges by 25% to $42 the position would be worth $8400 or 23%. So while this bullish trade looses money on a down draft in gold price the loss is reduced by about 2%.

Some other points related to a down side scenario include:

  • There is some chart support at its current 200dma around $54, so hopefully this could represent a possible no gain exit point for the trade.

  • Miners claim seem to say their costs to mine gold is around $500 an ounce. Even if gold falls below $1000 they will still be making money an at some point should become a value.

GLD and GDX rise.

In this case, the GDX put would likely expire and the GLD option would become in the money. For example. If the price of GLD rises by 10%, (to $145) and we let the trade run the call option would be worth $800. An $800 gain over the $10,800 net risked capital is a return of 7.4%. This slight slippage of return seems worthwhile when balanced against the 2 % downside protection described above. If gold were to spike by 25% to $165. The GLD option would be worth $2800. The $2800 return over the $10,800 of risk capital is a 26% return. A slight leverage advantage that increases if the price were somehow to spike even more,

In reality if the price starts to move up it is likely that an opportunity to modify the trade would present itself. Specially, on a price rise there should be a chance to cover the short put to take the risk capital off the table. To offset the cost of covering the put it might also be prudent to sell a further out of the money call turning the GLD position into a call spread.

GLD and GDX trade relatively flat.

In the unlikely event that the price of gold stays right around its current level and both options expire we get to keep the $400 in net option premium. This $400 over the $10,800 risk capital is a return of 3.7% over 5 months. Better than buying a short term bond!

In conclusion, This trade first and foremost meets the objective of providing a portfolio exposure to gold. By using this trade structure, a person gets paid if nothing happens, reduces the downside risk by a few percent, keep the upside intact , and sets up the opportunity to remove risk or gain more leverage on upward moves in the price of gold.

Disclosure: I am long GLD, GDX.

Additional disclosure: This posting is for informational, educational and entertainment purposes only and should not be considered investment advice.