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How To Hedge Your Gold Holdings

|About: SPDR Gold Trust ETF (GLD)

In a recent article titled "Gold's Unraveling Had a Few Harbingers," it mentions that "put buying" possibly contributed to the sell off in gold.

Markets opened with furious trading and deeper declines, as some investors sought the safety of puts, options that protect the holder by conferring the right to sell at a prearranged price, which potentially added to selling pressure in the market.

After reading the article I thought it might be a good time to review investment strategies that help protect asset values during a crisis or crash. The above quote mentions a "put." A put option allows the buyer to "put" the security to the seller at a pre-determined price. Buying a put can be considered buying portfolio insurance. Take for example a person that owns gold and it is trading at $1,500, but they are very nervous about their holdings and can't sleep at night. They don't want to sell it because it has done so sell, and paying all that money in capital gains taxes is simply out of the question. Buying a put option allows the sleepless investor to lock in their gains, continue to participate if gold goes higher and avoid paying capital gains taxes...for a price.

Here is how it works. Because this article is geared to the individual investor, I will use options on SPDR Gold Trust (NYSEARCA:GLD). The strategy discussed will also apply to physical gold, but requires a simple conversion.

Assume GLD is trading at $135, and you want to buy insurance against a further drop. The way you would do that is by buying a $135 put option. Options on GLD are offered in monthly increments, so we will use the May 2013 options for this example. If longer term insurance is preferred, there are other months available as well, but the longer the term, the more expensive and less liquid they are. Currently the May 2013 $135 put option has an ask of $4.25, the January 2014 $135 put option has an ask of $13.60, or about 10% of the current price of GLD.

With GLD trading at $135, the sleepless investor goes out and buys the GLD May 2013 $135 put option for $4.25. For about 3%, $4.25/$135, the sleepless investor has now purchased insurance against a further drop in gold. If GLD drops in price anytime between now and the expiration date of the third Friday in May, the sleepless investor is protected. If GLD drops to $100, the Sleepless Investor gets to sell their GLD to the person that sold them the put for $135. If GLD drops to $75, the Sleepless Investor still gets to sell their GLD for $135. If GLD drops to $1, the Sleepless Investor still gets to sell their GLD for $135. It is that very reason that the above quote highlights why put buying can contribute to a market decline. If a large number of holders of gold already own puts on their positions, the fall in gold prices is irrelevant to them, in fact because the put premiums expand during a crash, they are actually benefiting from the fall.

The sheer swiftness of gold's decline on Monday meant that investors were willing to pay a premium for put options on gold and silver-backed exchange-traded funds, a centerpiece of his strategy. His fund sold its holdings.

"We didn't think it would unravel so quickly," he said.

Ok, its not really that easy. I left out a few details. The first detail is that options contracts are for blocks of 100 shares. If you own 100 shares of GLD, you would buy 1 put option, if you own 1,000 shares of GLD you would buy 10 options, and if you own 10,000 shares of GLD you would buy 100 shares of GLD. The second detail is that to hedge physical gold with GLD options, you first have to convert your physical gold value into an equivalent number of GLD shares. GLD trades for $135 and an oz of gold sells for$1,390, so roughly 1 oz of gold represents 10 shares of GLD. If you own 10 oz of gold, you effectively own 100 shares of GLD, so you would buy 1 put option. The third detail is that you need to have your brokerage account allow for the purchasing of options. The forth detail is that if the price of gold falls, and the put option is "in the money" at expiration, the GLD will be sold automatically. If you want to prevent the generation of capital gains on your GLD holdings, you would need to sell your put option before the end of trading on expiration date. Taxes will be paid on the gain from the option, so you don't avoid taxes completely. Owners of physical gold don't have the option to let the options expire because they don't have GLD to deliver against the put. They would need to have enough cash in their account to buy the shares of GLD needed to be delivered. For that reason, it is best to discuss this strategy with a financial advisor, the devil is always in the details. The last detail is that the above example is for an "at-the-money" put, meaning that GLD was trading at $135 and the put option had a strike price of $135. If I had used the $130 put, or an "out-of-the-money" put, GLD would only be protected from loss below $130. This is just another reason why it is best to discuss these strategies with an investment professional.

In conclusion, investors in gold that do not want to sell their holdings, and believe that gold is a good long term investment, but can't sleep at night with the recent volatility have investment strategies that may help them rest better and protect their capital...for a price. The easiest way to hedge your GLD holdings is through a put buying strategy. Buying a put option basically provides insurance against a further drop in the price of GLD. While the concept is relatively simple there are details that make is rather complicated. Because of those details, it is best to consult an investment professional before ever executing an option or hedging strategy. Having the decimal off by 1 place can be extremely costly. The benefits may however outweigh the risks if you are losing sleep, and consulting an investment professional on these strategies may help you sleep even better.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I 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.