Volatile Gold Prices Create A Perfect Shorting Opportunity

 |  Includes: DUST, GLD, NUGT
by: Money Crashers

Over the past three years we have seen gold trade from $900 to $1,900 per ounce. Yet, since September, gold has bounced up and down locked in a range and has gone nowhere. Is it time to take some short-term risk off the table and play the range instead of swing trading or betting on a direction?

Volatile Gold Prices Means Profit
I want to be clear about one thing - this article is not about the long or short case for gold. Actually, I am a gold bull and I see a significant upside. But that is totally irrelevant for the purpose of this gold technique. Whether you are ultimately a gold bull or bear, you can profit from volatility by taking advantage of a compounding weakness in leveraged funds.

As you can see in the chart below, the past seven months of gold prices have been volatile and basically trendless. The diagram is for the non-leveraged SPDR Gold Trust fund (GLD).

Shorting Gold ETFs
Here is the setup: short the SPDR Gold Trust fund and use one-third that dollar amount to short the Daily Gold Miners Bear 3x Shares (DUST). In theory, one should cancel out the other for a delta neutral portfolio. If GLD goes up and you lose 10% on $100, you should profit by 30% on the $33 invested in DUST, which means $10 goes from one pocket into the other. This looks like a perfect hedge at first appearance, but it really isn't and that is how you make money. Let me explain.

3x Leveraged ETFs
Some erroneously think that leveraged ETFs suffer from time decay. One look at a long-term chart tells you that something is wrong with leveraged ETFs since the Russell 2000 is trading about the same level it was 12 months ago but the 300% leveraged ETF of the Russell 2000 is down over 30%. Why the difference?

The reason behind this has to do with certain ETFs being leveraged 3x on a daily basis. If prices chop up and down without trend, the fund will shrink. If prices go up day after day, the leveraging will compound the gains. Markets generally have more up and down see-saw action than they have consecutive days of pure jet fuel, which makes this strategy work in most markets.

A Simple Example of How Compounding Works
Consider how this works below:

  • Day 1 - $10
  • Day 2 - $12
  • Day 3 - $10
  • Day 4 - $12

By Day 4 you have a 20% gain. What if a triple leveraged ETF mirrored these gains? Day 2 goes up 60% or triple the amount of the underlying gain. The 3x fund would go from $10 to $16. Then prices go down 50% the next day (3 x 16.7%). Prices are at $6. Another 60% rise puts us at $9.6 which is significantly less than the 20% overall gain of the underlying.

Notice how the compounding effect works with 3 days of straight gain:

  • Day 1 - $10
  • Day 2 - $12
  • Day 3 - $14.40

While prices went up 44% in the underlying, note that the 3x leveraged will be up 156% since the third day compounds the gains of the previous day (or 60% on top of 60% gain). The point is that leveraged ETFs lose value in a volatile marketplace compared to the underlying. If you are short GLD and short a triple leveraged bear gold ETF - you will have a hedged position that gains from a trendless and volatile market. Well, you pretty much profit from anything except if gold moves in one direction with great zeal day after day for a prolonged period of time. The real example using gold funds is next.

Shorting Gold and Leveraged Gold Funds
On September 6, 2011, you short 100 shares of GLD at the price of $184.58 for a total of $18,458. You take one-third this amount to short the triple leveraged gold bear ETF, $6,153 of capital at a price of $29.72 is 207 shares.

On March 2nd, your shares of GLD are worth $16,634 while your 207 shares of DUST have a value of $6,611.58.

  • You earn $1,824 from covering your short position in GLD
  • You lose $458.58 from covering your short position in DUST

Your net of $1365.42 was based on shorting $24,611 of shares which you should be able to do on margin. If you can short GLD with 30% margin and DUST with 75% margin, this means you made 13.4% return in under six months.

Alternative Strategies
You can also go long GLD and short the gold bull 3x leveraged ETF (NUGT) for the same sort of position. Whether doing this or shorting both GLD and the leveraged bear fund makes more money really depends on how far and in which direction gold jumps on any given day, and how many of these up or down days occur in a row.

If you want to ramp this strategy up a level, short both of the leveraged funds (DUST and NUGT) with equal dollar amounts to potentially profit from both positions. This would be my favorite of the two plays, but keep in mind that margin requirements are much higher on leveraged funds than non-leveraged. The two-year chart below reveals how the two funds with an inverse relationship lose total value over time as they track lower and lower. Shorting both funds would have resulted in over 30% profits with DUST and over 40% profits with NUGT. Of course, when and how to rebalance is another issue altogether.

So whether you think gold prices will shoot up to $10,000 per ounce or fall down to $300 over the long-term, you can capitalize on temporary ambivalence right now by creating a delta neutral portfolio that profits from the negative compounding effects of leverage on whipsawed prices. While time decay is not associated with this technique, you can profit from volatile gold prices by shorting a leveraged fund and hedging it with a non-leveraged ETF - or by shorting two leveraged funds that are inverse to each other.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.