Why You Should Consider Purchasing Some Puts on GLD

| About: SPDR Gold (GLD)

I used to run a hedge fund, so it’s not too uncommon for me to get inquiries from people about what they should do with their money. About a month ago, I got an e-mail on ‘facebook’ from a guy I went to high school with asking me how he could get more exposure to precious metals in his 401k. I’d been following gold a little, and was aware of the bull story (china demand, inflation expectations, the end of fiat banking, the end of the world, QE2 through 10, The Bernack, etc, etc, etc) and felt it was probably best to leave it alone as I’m not really a momentum guy. It seemed to have a mind of its own and on the express train from $275 in 2001 to infinity some time in 2011. I kindly let him know that there were some ETFs, etc, but that he was probably better off buying the S&P as 40% of the revenue of the constituent companies are from overseas and a weak dollar would be good for exports, and that I was looking forward to hearing from him again in another 10 years.

Then, about a week later, I was talking with an Artist whom I was commissioning for a project. Her husband had just began working for a company that was buying gold jewelry from people to melt down. It eerily brought back visions of a sock puppet selling pet food on the internet and my Dentist’s assistant buying an $800,000 house. So I went to work.

I hate shorting things, because it is damn hard and often crowded, and I’ve been squeezed a few times in my day. I usually buy puts instead, but usually the volume is too rich for me so I just sit on the sidelines and moan to myself about how obvious it was to short pets.com. But when I looked at the puts on GLD, I was pleasantly surprised. The implied volume was in the low 20s and they were super liquid… you could buy at-the-money puts almost a year out for under a 10% premium.

Now, cheap puts alone don’t make a good trade, as I don’t really have the patience or computing power to delta hedge them, so I needed another reason to buy them. So I looked for correlations, and interestingly enough, my PA was highly correlated to the price of gold (which was probably really a correlation to the dollar). So I had a hedge…. PnL volatility problem solved.

I called my broker, initiated my hedge and breathed a sigh of relief, but then I started to do a little more research. Since then, I’ve been steadily adding to my position, to the point where it is more than a hedge, and is it is actually one of my favorite trade ideas for 2011.

Here’s why:

The largest private buyer of physical gold in the world is the GLD trust. The trust was formed in 2004 by the World Gold Council to create demand for the excess gold production supply that existed and get the price of gold up. And in that regard, it has been tremendously successful. Since inception, it has purchased 1,300 tons of physical gold, or more than 8% of the ~15,000 tons of gold that has been mined over that period. In 2009 they bought over 350 tons of gold, or almost 15% of the ~2500 tons of gold produced that year. So far in 2010, they’ve purchased around 160 tons (or around 6-7% of production). To say that they weren’t influencing the price would be like saying Fannie and Freddie had nothing to do with the housing bubble.

The 1,300 tons of gold represents more than a ½ years of Gold mining production at current rates.

The trust is not a tax efficient vehicle. Holders of the GLD ETF pay a 28% collectibles rate instead of the 15% long term capital gains rate.

Almost every holder of the GLD trust is currently in the money.

Inflation fears are over hyped as the velocity of money has slowed.

As a opposed to other precious metals, Gold has almost NO industrial uses. The largest sources of demand are jewelry production and investment purchases.

The GLD trust is open ended, so it is constantly issuing and redeeming baskets of shares by transacting in physical Gold.

Profit taking, lower inflation expectations and an improving economy could lead to the GLD trust to begin selling physical on the open market.

The removal of the largest buyer and the introduction of more supply to the market may cause a decline in the price of gold.

In the 15 months since inception that the trust has sold physical gold, the price has declined an average of 2%. (GLD trust has only sold in 15 of the 72 months since inception)

In the 6 months since inception that the trust has sold more than 20 tons of physical gold, the price has declined an average of 6% (and as much as 9%).

My theory is this - - there is a decent probability that the GLD trust could become a seller some time in the next twelve months. I don’t know what might cause it – it could be profit taking, it could be lowered inflation expectation, it could be an improving economy, it could be taxes, it could be anything. But it if it happens, and it is sustained, gold prices could move down significantly from these levels. And given that the implied vol is in the low 20s and the cost of puts is so low, you can buy Dec 130 puts for around $10 bucks – or a 7.5% premium. The breakeven even is around $1250 in Gold… If you think there is a chance that it drops below $1250 in the next 12 months, I think the trade is a no brainer.

I welcome comments and criticism. Thanks.

Disclosure: I am short GLD.

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