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In his Financial Times column over the weekend ("In times of trouble, go with the money flow"), John Authers noted the sentiment at a recent CFA Institute conference was that the recovery from the March '09 lows wasn't likely to last much longer, and that more investors were moving into U.S. farmland, emerging markets currencies, and gold as a result. Of those asset classes (and of gold, in particular), Authers wrote:

[T]o a great extent, to get into these investments is to make a bet that a bubble is under way and that you will have the wits to get out before that bubble bursts.

Betting on a bubble

Of course, many of those who are long gold will disagree with Authers' characterization of it as a bubble. This post, though, is directed to those who believe it might be a bubble but hope to profit from investing in it nonetheless. Getting out of a bubble before it bursts can be tough to time right. Another approach is to bet on the bubble and hedge against the bursting of it.

Precious metals ETFs

In a post last month ("Does Downside Protection for Precious Metals ETFs Make Sense?"), we noted that some precious metals ETFs and ETNs -- among them, ETFS Physical PM Basket Shares (NYSEARCA:GLTR), ETFS Physical Platinum Shares (NYSEARCA:PPLT), ETFS Physical White Metals Basket Shares (NYSEARCA:WITE), iPath DJ-UBS Precious Metals TR Sub-Index (NYSEARCA:JJP), and UBS E-TRACS Long Platinum TR (NYSEARCA:PTM) - don't have options traded on them, so they can't be hedged directly with put options. But, of course, gold has a widely-traded, optionable ETF that tracks it, the SPDR Gold Trust (GLD).

In the table below, I've listed the cost (as of Monday's close) of hedging the SPDR Gold Trust and four other precious metals ETFs against greater-than-20% declines over the next several months, using the optimal puts for that. First, a reminder about why I've used 20% as a decline threshold, and what optimal puts means in this context.

Decline thresholds

As I noted in a previous article on hedging, the threshold I usually use when I hedge is 20% (i.e., I want protection against any decline worse than that). The idea for a 20% threshold came from a comment fund manager (and Stanford finance Ph.D.) John Hussman made in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Hussman was referring to equities there, not precious metals ETFs, but 20% still seems like a reasonable threshold to me - large enough that it reduces the cost of hedging, but not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.

About optimal puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. With Portfolio Armor (available in Seeking Alpha's Investing Tools Store, and as an Apple iOS app), you just enter the symbol of the stock or ETF you’re looking to hedge, the number of shares you own, and the maximum decline you’re willing to risk, (your threshold). Then the app uses its proprietary algorithm to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

A difference between this month and last

Readers of last month's article on hedging precious metals ETFs may notice that the cost of hedging against a >20% decline in GLD looks considerably higher this time -- 0.89%, versus 0.28% last month. One reason for that difference is that the optimal puts on GLD mentioned in last month's article had five months until expiration, and the optimal puts on GLD listed below have seven months until expiration. All things equal, options with expirations further out generally cost more.

Symbol

Name

Cost of Protection (as % of position value)

GLD

SPDR Gold Trust

0.89%***

SLV

iShares Silver Trust

7.00%*

DBP

PowerShares DB Precious Metals

2.02%*

SGOL

ETFS Physical Swiss Gold Shares

3.85%***

SIVR

ETFS Physical Silver Shares

10.16%***

*Based on optimal puts expiring in October, 2011

***Based on optimal puts expiring in December, 2011

Source: Gold: Betting (And Hedging) on a Bubble