Gold Gets Hammered

Includes: GLD, IAU
by: David Pinsen

Gold gets hammered

Gold futures for December delivery dropped 5.9 percent, to settle at $1,639.80 on the New York Comex on Friday afternoon. The gold-tracking ETFs SPDR Gold Shares (NYSEARCA:GLD) and iShares Gold Trust (NYSEARCA:IAU) were down 5.47% and 5.60%, respectively, on the day. Since its recent peak on September 6th, gold prices have dropped 15%.

Gold is malleable -- are gold investors?

One of the physical properties of gold is that it is highly malleable, so gold can get hammered (into gold leaf, for example, which is pictured above) without breaking.

Whether gold investors will be as resilient if this correction continues remains to be seen. Kitco noted on Friday, though, that Comex traders will have to put up more cash to trade gold futures, as the CME Group, Inc. (NASDAQ:CME), the parent company of the New York Mercantile Exchange (of which the Comex is a division) raised gold margins by 21.5%.

Hedging and malleability

As we noted in a post last month ("Gold Goes Parabolic, Hedging Costs Rise"), one of the advantages of being hedged is that it obviates the need to panic or run for the exits:

If you're hedged when the next correction in gold hits, you'll have the breathing room to consider whether that correction is analogous to 1980's crash from gold's generational peak or to 2008's sharp, though temporary, correction.

Remember that in 2008 gold fell to a low of $712.50 per ounce, after having peaked at over $1,011 per ounce earlier in the year. A gold investor who had been hedged could have, if he were still bullish on gold at that point, sold his hedges and used the proceeds to increase his position in gold.

Malleability works as a metaphor here, since a hedged gold investor's portfolio could potentially handle getting hammered by a gold correction, more so than an unhedged portfolio. Consider, for example the hypothetical gold investor we mentioned in that post last month.

Hedging a gold position on August 22nd

In the article mentioned above, published on August 23rd, we gave an example of how a hypothetical investor with a $113,000 position in gold could hedge against a greater-than-20% drop in gold between then and March 16th of next year, using optimal puts on GLD as a proxy. Below is a screen capture of the optimal puts at that time to hedge 612 shares (equivalent to approximately $113,000 then) of GLD, followed by a current quote on those options. First, though, a quick reminder about what optimal puts are.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor, our hedging tool, uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Those puts on Friday, September 23rd

Note that the ask price of the puts in the screen shot above, taken on August 22nd, was $3.90. In the screen shot below, it's $11.40.

The nonlinearity of options

Note that on a day when the underlying ETF GLD dropped 5.47%, these put options rose 60.14%. This nonlinear, or asymmetrical movement is what enables a relatively small position in put options to hedge a significantly larger dollar value of an underlying security.

Softening the blow

Between August 22nd and September 23rd, GLD shares dropped in value by about 13.4%. Those optimal puts were the ones to hedge against a greater than 20% drop, not a greater than 13% drop, but, nevertheless, they did appreciate in value as the share price of the underlying ETF declined, softening the blow somewhat on the investor's portfolio. Taking into account the appreciation of the puts, his combined GLD position plus its hedge would be down 10.4% now, rather than 13.4% if he were unhedged.

The optimal puts to hedge that GLD position now

The best time to consider hedging is, of course, before a correction. But for those who are long GLD and are considering hedging now, the screen shot below shows the optimal puts to hedge 612 shares of GLD as of Friday's close.

Note that in this case, as in the previous example, the tool rounded down the number of shares of GLD we entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then presented us with 6 of the put option contracts that would slightly over-hedge the 600 shares of GLD they cover, so that the total value of the 612 shares of GLD would be protected against a greater-than-20% decline. For investors looking to hedge a 100 share position of GLD against a greater than 20% decline, the optimal puts as of Friday's close weren't the ones below, but the $132 strike March puts.

Disclosure: I am long puts on GLD.