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GLD still relatively inexpensive to hedge, despite its recent drop

In a Seeking Alpha article written on November 10th ("Hedging The 10 Highest-Rated Gold and Silver Stocks"), in addition to looking at the hedging costs of gold and silver mining stocks, we looked at the hedging costs of the gold-tracking ETF SPDR Gold Trust (GLD). Since then, as the chart below, shows, GLD has dropped more than 11%.

click to enlarge

Despite its recent drop, though, GLD is still relatively inexpensive to hedge, at least in comparison to the five most actively traded ETFs, as the table at the bottom of this post shows.

Hedging GLD -- Then And Now

In this post, we'll look at the current optimal puts to hedge the SPDR Gold Trust ETF (GLD) against a greater-than-20% drop over the next several months, along with the current costs of hedging the five most actively traded ETFs. Before that, we'll take a look at how a previous hedge on GLD against a greater-than-20% decline reacted as the underlying ETF fell 11.15%. First, a reminder about optimal puts and decline thresholds.

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 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.

Decline Thresholds

In this context, "threshold" is the maximum decline you are willing to risk. Another way of thinking about it is this: the percentage you can tolerate losing. In this case, since we're using 20% as a decline threshold, we are indicating that we could tolerate a 20% loss, but not a loss greater than that. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position).

The Optimal Puts To Hedge GLD On November 10th

These were the optimal puts to hedge 100 shares of GLD against a greater-than-20% drop over the next several months on November 10th.

The ask price of those put options was $4.50. As the screen capture above shows, to be conservative, Portfolio Armor calculated the initial cost of the options contract (1 contract = 100 put options) on that ask price. In practice, though, an investor could probably have purchased those puts at some price between the bid and the ask price.

The screen capture below shows those same put options as of Wednesday's close. Note that the bid-ask spread of $6.75 by $6.90.

Limiting Downside With A Hedge

Here's what our hypothetical GLD investor's underlying stock + option hedge would have looked like on November 10th:

Option Hedge: 1 contract (100 puts) of GLD120616P00142000 at the ask of $4.50 = $450

Underlying ETF: 100 shares of GLD @ $171.14 per share = $17,114

Total on November 10th = $17,564

And here's what our hypothetical GLD investor's combined position (underlying ETF + option hedge) would have looked like on Wednesday, December 14th:

Option Hedge: 1 contract (100 puts) of GLD120616P00142000 at the bid price of $6.75 = $675.

Underlying Stock: 100 shares of GLD @ $152.89 = $15,289

Total on December 12th = $15,964

Net Decline Of Hedged Position As GLD Drops 11.14%: 9.1%

Remember that, on November 10th, by buying the optimal puts to hedge against a greater-than-20% decline, our hypothetical GLD investor was indicating that he was willing to tolerate a 20% decline -- but not a larger one. Let's say he decided to sell both his shares and his hedge on Wednesday, December 14th, after the ETF had declined 11.14% from November 10th. What loss would he have incurred? The difference in value between his combined positions on November 10th and December 14th was ($17,564 - $15,964) = $1,600, which represents a 9.1% decline. So, in this case, even though the ETF only dropped about 11% -- a little more half as much as his initial decline threshold (20%) -- his hedge still offset part of that smaller decline.

The Optimal Puts To Hedge GLD Now

Below is a screen capture showing the optimal put option contract to hedge 100 shares of GLD against a greater-than-20% decline as of Wednesday's close. Note that this is a different options contract, with a lower strike price than the one in the screen capture above, as this is a hedge against a 20% drop from a lower share price. Note also that the cost of protection as a percentage of position is a little lower than in the screen capture above from November 10th; this may be due in part to the shorter time to expiry of the optimal puts this time.

Current Hedging Costs For GLD and the 5 most active ETFs

Except for GLD, the ETFs in the table below are listed in order of their share volume during Wednesday's trading, with the most actively traded one, SPDR S&P 500 Trust (SPY), listed first.

Symbol

Name

Hedging Cost

SPY SPDR S&P 500 Trust 3.33%*
XLF Financial Select Sector SPDR 6.61%*
IWM iShares Russell 2000 Index 6.50%*
EEM iShares MSCI Emerging Markets 6.08%*
QQQ PowerShares QQQ Trust 3.35%*
GLD SPDR Gold Trust 1.99%*

*Based on optimal puts expiring in June, 2012.

Source: Hedging GLD With Options Before And After Its Recent Drop