There has been lots of talk about the impending US debt "crisis", the European debt crisis and perhaps even a Japanese debt crisis. I will be the first to say that I do not know what will be the ultimate outcome of all this money printing and issuance of debt by developed countries, but I have an uneasy feeling. For every action there is an equal and opposite reaction; this applies in nature and financial markets are no different. There will be an ultimate price to pay for debasing the world's reserve currencies (EUR, USD, and yen). Something inside of me tells me that this will all ultimately result in global inflation that will make the 1970s look like child's play.
So our view is that inflation is going to "super" spike. Now let's look for the most efficient way of hedging or insuring against a complete breakdown in the faith in government debt. I want an instrument that gives me an exponential or parabolic payoff profile.
Over the last few weeks I have been suggesting to clients that they consider putting an allocation of their capital into the deepest OTM call options on a selection of gold stocks that have a high gearing to a movement in the price of gold, a liquid option market, and options where the implied volatility is trading more or less at all time lows. One such stock is Yamana Gold (NYSE:AUY). Below is an index of implied volatility on ATM 12 months to expiry options on AUY.
click on image to enlarge
As you can see (sorry for the terrible graph but this is about as good as Bloomberg graphs get), it seems that option writers have no fear about a dramatic move in the price of Yamana (or gold stocks in general).
Putting numbers to it, $1000 will get you about 20 Jan 13 $20 strike calls. If Yamana trades above $20 before Jan 13 it will give you the equivalent underlying exposure of $40,000! Yes I say "if" because Yamana has to appreciate some 67% in 18 months but I don't think that will be too demanding if there is a global paper currency (inflation) crisis!
Will gold shares spike dramatically in the next 12 months? I don't know but if they do we are positioned to do very nicely. Of course if they don't we will lose our premium, which wasn't very much in the first place. Remember, it isn't a case of being right or wrong, rather how much you stand to lose if you are wrong vs. what you could potentially make if luck comes your way!
Disclosure: I am long AUY, and AUY Jan13 20 strike calls.