Tom Szabo

Crude Oil and Gold: Not Worth Worrying Over

An alternate theory gaining a bit of credibility compared to "first a slight correction, then to da moon!" is that commodities, oil and gold will trade in a wide consolidation pattern during the next few years. There is no fundamental reason why oil couldn't be trading at $50 today just like there is no fundamental reason that it is trading at $80. Similarly, I think the idea that gold cannot trade for an extended period in a price range of perhaps $700-$1100, but instead must inevitably trade much higher in the short run, is a sign of groupthink. I have a large exposure to precious metals in the form of physical holdings and stocks so I would love for gold to explode in price but at the same time I believe it's important not to drink the market's Kool Aid.

Gold (and Gartman) Haunting Some Investors

Brad, you don't need delta when AT THE MONEY. You receive one dollar of insurance for each dollar move against the underlying position. The cost of that insurance is the time value and it is directly related to volatility. We can ignore the greeks completely as they all disappear at expiration of the option, which is the time period we are seeking to insure. In other words, you wouldn't pay more in time premium than you would expect the underlying could move between now and expiration of the option.

I understand this wasn't the point of your article and I did read Hedging Gold's Volatility. I also understand how one could try to strip out alpha using such a method. But there are problems with the method as presented. I'll pick just three. First, you chose a "convenient" timeframe where DZZ was generating returns, not dragging on them. This made the return and risk-to-reward of the hedged portfolio artificially high compared to real world results. Second, I don't see where you took into account the fact that it took about $20,000 to acquire the hedge. In other words, $20,000 Hecla with a $20,000 DZZ hedge should be compared to $40,000 Hecla. I presume this would make the hedged returns when gold is climbing (which is most of the time in a bull market) even more pathetic. Third, you've created alpha but that doesn't mean it will always be positive. That's because you don't have ANY beta in the hedged portfolio at all. So, when beta is large and positive, you are going to have a large and negative alpha. And that would buy you exactly one calendar quarter as head of a hedge fund.

Gold (and Gartman) Haunting Some Investors

Yes, riskwise they are the same.

No, we don't need to examine the unknowns when buying an at-the-money put against a long position. We know everything we need to know: the premium and the term. We can divide the premum into the price of the underlying and annualize the term, and voila we have the annual cost of the put insurance expressed as a percentage of our position. That pretty much boils everything down to volatility.

Aha, now I get what you were trying to achieve! The fabled, non-existent (positive) alpha in gold stocks as a group! Too bad nobody has seen that in years, and even when it did exist, it always seems to "outperform" on the way down. In other words, gold stock volatility is skewed. Have you checked that for both GDX and DZZ?

If the goal is to seek alpha in gold stocks, you probably want to put together your own porfolio and not use GDX. Ideally, you would pick stocks that have a skew profile that is inverse to DZZ and obviously have good fundamental prospects.

Gold (and Gartman) Haunting Some Investors

Brad, my point was that DZZ neuters the upside, which is a real cost you must consider.

A call option is not the same as a long position combined with a put option. For one, the call option will generate capital gains if you sell for a gain or it expires in the money. Meanwhile, the long position hedged with a put remains tax free as long as you hold it. There are other very fundamental reasons why you cannot equate the two.

Even then, a call option is still better than your long GDX short DZZ strategy. As I already stated, the option will let you keep the entire upside while DZZ neuters it. The cost of capital is also much lower with the put; you fail to consider the time value of money tied up in GDX and DZZ. Worse, one really can't know how good a hedge DZZ is going to be up front, as you reminded us. This causes you to allocate too much to the short leg or else suffer losses related to poor correlation.

With an at-the-money option, you know precisely your loss up front--it is the option premium. In fact, buying a put to hedge a long position should be viewed as a tradeoff -- taking a known loss in exchange for an unknown one. You might know this by another term: insurance.

As for your suggestion we should do some math to figure out why the long GDX short DZZ are not perfectly correlated, that would be a waste of time. Everybody knows gold and gold stocks don't move in perfect unison. It has nothing to do with company management. But even if they were perfectly correlated, you couldn't exactly offset a loss since the correlation is not a flat line along every price point. The easiest way to see this is to realize that the long leg can go to infinity but the short leg can only go to zero. That means if you think GDX is going up 1000% in the next few months but might also go down 50%, then DZZ might be an okay tool (still not as good as a put option) since it could only go to zero which still gives you 900% overall gains. The reason is simple: an option gives you more leverage along the entire price curve. This works in inverse as well but to a much lesser extent. Thus the math is a bit more complicated than you imply: it is not linear math but rather logarithmic math (looking for my high school math textbook as I write this)

Gold (and Gartman) Haunting Some Investors

Hello! Hello? I don't hear anybody discussing PUT OPTIONS here! You know, they have them for both GDX and GLD (just introduced). An attempted offset like DZZ & GDX is not really an investment hedge, it's a waste of time. You want to keep exposure in at least one direction! In April, you could have bought Dec GDX put options at the money for about 5. That's an automatic loss of 10% but you would have no further downside exposure, would get to keep all the upside on GDX, and would still have the money left over from not having to buy DZZ. Of course, there hasn't been any upside so far but next time could be different.