Gold's Haven Status Questioned
In an article in Saturday's Financial Times ("Gold tumbles below $1600 as metal's haven status fades"), Emiko Terazono noted a change in gold's correlation with putatively risky assets:
During the past few years, gold has generally been stronger during times of a sell-off in risky assets. However, since the end of last year, it has been losing its haven status.
Its fall through an important support level of $1,612 a troy ounce this week, and [its fall] through a weekly support line, to trade at $1,584.75 yesterday, have only confirmed the downward trend.
Terazono included a contrary view in his article, quoting Jeffrey Currie of Goldman Sachs, whose firm maintains a six-month gold price target of $1,840 per troy ounce. Currie acknowledged investors' recent move into the US dollar but argued that concerns about the dollar made it "too early" for it to regain its haven status (implying that risk-averse investors would turn to gold instead).
Hedging Against A Loss Of Gold's Haven Status
If an investor who is long gold believes the metal has lost its haven status, and its recent downtrend will continue, then exiting his gold position makes sense. But what if he is uncertain? If he exits, he'll avoid a near term drop, but he won't participate if gold goes on a run in the next several months, as Goldman Sachs predicts. An alternative approach here would be to continue to buy, or to hold his gold position, but hedge.
What makes this an attractive alternative to consider is the relatively low cost of hedging gold now. For example, the cost of hedging $1,000,000 in gold over the next several months, using optimal puts on the SPDR Gold Trust ETF (GLD) as a proxy, is now $9,425, or 0.94% of position value. In this post, we'll show the specific optimal put option contracts to provide that level of protection, and we'll also include a table showing the cost of hedging three other gold-tracking ETFs that can be used as proxies for gold.
For comparison purposes, I've added the Market Vectors Gold Miners ETF (GDX) to the table. First, a reminder about what optimal puts are, and a note about why we're using 20% decline thresholds here. Then, a screen capture showing the current optimal puts to hedge $1,000,000 in gold using the SPDR Gold Trust ETF as a proxy.
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.
In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. 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). I have used 20% decline thresholds for all of the names here because it's a large enough decline threshold that it lowers hedging costs, but not so large that it precludes a reasonable recovery. A couple of examples may help illustrate this:
- After a 30% decline, it would take almost a 43% gain for an investor to get back to even.
- After a 20% decline it would only take a 25% gain to get back to even.
The Optimal Puts To Hedge $1,000,000 in Gold Using GLD
Below is a screen capture showing the optimal put option contracts to buy to hedge $1,000,000 in gold against a greater-than-20% decline between now and December 21st, using the SPDR Gold Trust ETF as a proxy for gold. To get the number of shares to enter below, we divided $1,000,000 by the current price of the proxy ETF GLD ($153.56) to arrive at approximately 6,510 shares.
Note that, since one put option contract covers 100 shares, the app rounds down the number of shares entered to the nearest hundred, and, if necessary, slightly over-hedges the remaining number of shares, so that the total value of the position is protected according to the decline threshold the investor specified. Also note that, to be conservative, the app calculated the cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).
Hedging Costs as of Friday
The hedging costs below are as of Friday's close, and are presented as percentages of position values. Bear in mind that hedging costs can fluctuate quickly, as we noted in an article earlier this year ("After Bernanke's Testimony: Hedging Precious Metals ETFs").
|GLD||SPDR Gold Trust||0.94%**|
|IAU||iShares Gold Trust||0.97%*|
|SGOL||ETFS Physical Swiss Gold||1.34%**|
|DGL||PowerShares DB Gold Fund||2.29%*|
|GDX||Market Vectors Gold Miners||4.50%*|
*Based on optimal puts expiring in October.
**Based on optimal puts expiring in December.