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Precious Metals ETFs

With gold hitting new highs Wednesday, here is an updated look at the hedging costs of gold and other precious metals ETFs.

In previous posts, 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 (NYSEARCA:GLD).

In the table below, I've listed the cost (as of Wednesday'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 optimal puts.

Dollar and Treasuries Comparisons

For comparison purposes, I've also included the PowerShares DB USD Bull ETF (NYSEARCA:UUP), and the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT). First, a reminder about what optimal puts mean in this context and why I've used 20% as a decline threshold.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available on the web 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.

Decline Thresholds

You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary 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, currency, or Treasuries 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.

A Step by Step Example

There is a step by step example of finding optimal puts for one of the ETFs listed here, with screen shots, in this recent Seeking Alpha article, "Why You Should Consider Hedging if You Own Gold".

How Costs Are Calculated

To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).

Hedging Costs as of Wednesday's Close

The data in the table below is as of Wednesday's close.

Symbol

Name

Cost of Protection (as % of position value)

GLD

SPDR Gold Trust

1.10%***

SLV

iShares Silver Trust

5.26%*

DBP

PowerShares DB Precious Metals

1.53%*

SGOL

ETFS Physical Swiss Gold Shares

1.55%***

SIVR

ETFS Physical Silver Shares

8.97%***

TLT iShares Barclays 20+ Year Treasury Bond 1.16%***
UUP PowerShares DB US Dollar Index Bullish 0.10%***

*Based on optimal puts expiring in January, 2012

**Based on optimal puts expiring in March, 2012

Disclosure: I am long puts on TLT.

Source: Hedging Exposure to the Dollar, Treasuries and Precious Metals