Gold Remains a Great Hedge Against Inflation

Gold continues to perform well as fears of inflation and political instability in the Middle East threaten the stability of the dollar. Oil prices are also on the …

Gold continues to perform well as fears of inflation and political instability in the Middle East threaten the stability of the dollar. Oil prices are also on the rise, making it even more important to look into gold as an investment strategy. See the following article from Money Morning for more on this.

If you bought gold at any time during the first 10 months of 2010, you’re sitting on some pretty healthy profits.

And thanks to renewed inflation fears and the growing unrest in Egypt, Libya and other Middle Eastern nations, most forecasters believe the “yellow metal” still has lots of room to run.

But if you watched gold struggle during January 2011, you may also be worried about keeping those hard-won profits – even with the rebound and run to record highs that gold prices have made.

Not to worry: You don’t have to just sit around chewing your nails and worrying gold prices will suddenly plunge. Whether you hold physical gold, trade in gold futures contracts or own the shares of major gold-mining companies, you can “insure” nearly all of your profits against a short-term price decline with the help of a very simple options hedge.

Insuring Your Profits

Specifically speaking, the strategy that we’re advocating involves buying one or more “put options” to match the equivalent size of your gold-related holdings. That’s your “insurance policy.”

For those unfamiliar with options, a “put” option gives its owner the right to sell a specific underlying asset at a designated price for a limited period of time. For example, a June Newmont Mining Corp. (NYSE: NEM) put option with a strike price of 55 would give its holder the right to sell 100 shares of Newmont common stock at a price of $55 per share at any time between the date of purchase and the option’s stated expiration date – in this case, June 17, 2011.

[Options-Trading Tip: A “call option,” the other basic type of option, is the financial opposite of its put-option cousin. The “call” gives its holder the right to buy a given asset at a specified price for a limited period of time.]

Similarly, one June Comex gold put option would give its holder the right to sell one June gold futures contract (controlling 100 ounces of physical gold) traded on the Comex division of the Chicago-based CME Group (Nasdaq: CME).

The easiest way to explain exactly how this insurance strategy works is with an example, so let’s assume that you bought an April Comex gold futures contract when gold pulled back in late January, paying a price of $1,325 an ounce (making the full 100-ounce contract worth $132,500).

Gold rebounded through most of February, closing on Friday, Feb. 25, at $1,413.90 an ounce (the price that we’re using for this example). That means that your 100-ounce futures contract had risen in value to $141,390, giving you a paper profit of $8,890.

Given the Middle Eastern turmoil and the related rise in oil prices – all of which could ignite a conflagration of inflation and stall the global recovery – you would expect gold prices to continue their advance.

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But (and this could be a very costly “but”), you also believe that the odds are high that there could be at least a modest correction in prices before the April future comes due for delivery, forcing you to cash in.

What do you do?

The best answer would be to buy an at-the-money Comex put option – in this case, that would be the put with a strike price of $1,410 – giving you the right to sell your April gold futures contract at a price of $1,410 an ounce ($141,000), at any time prior to the expiration date on Monday, March 28.

Had you done that at the market’s open on Monday, Feb. 28, you would have paid a premium of $19.00 an ounce for the gold put – or $1,900 for the full option.

That’s the only cost for the hedge: No margin requirement is imposed, nor is there any additional risk over and above the premium paid for the put.

Even so, that might seem a bit expensive – but the protection it provides is well worth it.

For starters, you guarantee that you will give back no more than $2,290 of your existing (aforementioned) profit of $8,890 – no matter how far gold prices fall. Even if the market collapses completely – plunging gold futures prices to, say, $1,200 an ounce – the most you will lose is $2,290. That compares to a whopping loss of $21,390, had you held only the futures contract (and not used a stop-loss order).

By contrast, if gold prices keep climbing, you’ll continue to add to your profits, reducing the total gain by only the $1,900 you paid for the insuring put. For example, should gold soar to $1,600 an ounce – or $160,000 for the full futures contract – your added profit on the hedged position would be $16,710, just $1,900 less than the extra $18,610 you’d have made on the futures contract alone.

To clearly illustrate, the following table shows all the possible outcomes for this particular example at any gold futures price between $1,200 an ounce and $1,600 an ounce (the top line of the table shows the opening values for the hedged position).

A Flexible Strategy

Keep in mind that the example we outlined in the preceding graphic is just that – an example. And it’s just one example of a strategy that is surprisingly flexible and adaptable.

Indeed, the actual strategy itself can be adjusted in a variety of ways, depending on what your actual goal happens to be. For instance, had you chosen to buy the April $1,400 put instead of the $1,410 put, your cost would have been reduced from $1,900 to $1,450, though you’d have increased the amount of profit at risk from $2,290 to $2,840.

You also could extend the time frame of your hedge by rolling the futures contract to a future delivery month – from the current example of April to, say, May, June, August or October – and buying the matching put option. Expiration dates for options linked to those futures months are:

• May – Tuesday, April 26, 2011
• June – Wednesday, May 25, 2011
• August – Tuesday, July 26, 2011
• October – Tuesday, Sept. 27, 2011

[Options-Trading Tip: The days of the week vary because expiration dates for options on gold futures are defined as the “fourth business day prior to the start of the futures contract delivery month.”]

It’s also important to remember that this “insurance” strategy can be adapted to most other methods of investing in gold, so long as the securities or assets involved have related options.

The options on Comex futures – which have substantial liquidity (an average daily trading volume near 3,000 contracts and an open interest approaching 990,000 contracts across all months) – can be easily adapted to hedge physical-gold holdings over a limited period of time. All you need to do is buy one put option for each 100 ounces of physical gold you own.

Most of the leading large-cap and mid-cap gold-mining stocks also have options – generally traded on the Chicago Board Options Exchange (CBOE) – and you can insure your positions by purchasing one put for each 100 shares you own.

Some of the leading names that have very liquid option markets include the afore-mentioned Newmont, Barrick Gold Corp. (NYSE: ABX), Freeport McMoRan Copper & Gold Inc. (NYSE: FCX), Agnico-Eagle Mines Ltd. (NYSE: AEM) and Gold Fields Ltd. (NYSE: GFI), among others.

Options are also available on most of the popular exchange-traded funds (ETFs) that invest primarily in gold or gold stocks. For instance, highly liquid options can be purchased on a full range of expiration dates for the SPDR Gold Trust ETF (NYSE: GLD) and the iShares Comex Gold Trust (NYSE: IAU), both of which invest in futures and hold physical gold.

Since their price movements fairly closely track the actual price of gold, you can use the puts on these ETFs to achieve either of two goals. You can either:

• Directly insure your fund shares.
• Or insure smaller holdings in physical gold.

Just buy puts on enough ETF shares to match the present value of your bullion.

If you hold a portfolio of gold mining stocks, you can also do a broad hedge by purchasing puts on some of the ETFs that focus on mining shares, an example being the Market Vectors Gold Miners ETF (GDX).

In other words, regardless of how you’ve placed your bets on gold, it doesn’t have to be an all-or-nothing proposition. With a little study and the use of the appropriate options, you can easily protect your profits while continuing to stay in the game for more.

This article was republished with permission by Money Morning.


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