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I read a lot of gold commentaries. Most of them go as follows: buy gold because the U.S. dollar is doomed! The end.
While this theory has worked exceptionally well in recent years and could continue to be profitable for years to come, there is the risk that gold will suffer a major price collapse. Such a collapse could be sparked by any number of events, including central bankers uniting to support the U.S. dollar, a dramatic decline in commodity prices, or (further) desperate manipulation by the evil COT. Whether gold is poised to collapse or not, it is safe to say that there is no guarantee that the destruction of the dollar is imminent and/or that gold will continue on its upward path.
Your Basic Hedge
A put option gives you the right, but not the obligation, to sell something at a set price in the future. Using gold as the example, a February 2008 put option with a $750 strike costs around $1000 today. The buyer of this American option has the right to sell 100 ounces of gold at $750 on or before Jan 28, 2008. If gold is at $750 or higher on January 28 the option would not be exercised ($1000 loss). But if gold was trading at say at $749.99 or lower on January 28 the put buyer could sell 100 ounces at $750 (or $1000 profit for every $10 slide in gold). In other words, assuming the option is held until expiration, the February 2008 put in question requires $740 gold before it starts making money.
Putting the above put option into play, the example below assumes the investor purchases 50 ounces of gold at $800 an ounce and a single February 2008 $750 put option for $1000.
* I would implore anyone considering an approach like this to fully understand the risks/advantages of the position, many of which can not be covered in this brief commentary.
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Please note: the above hedging example may not reflect actual market prices, commissions, and other important statistical info that is essential before investing.
After deploying such a position if gold’s next stop was $900 an ounce the cost of hedging using the above example would not be that great (a $4000 hedged profit instead of $5000 unhedged profit). However, if gold moved lower by the same amount to $700 the hedged position would produce a break-even result versus a $5000 loss for the unhedged position. Clearly the above strategy craves volatility in either direction, but preferably to the upside.
Look at it this way: you walk into a coin shop and the dealer says ‘would you like to pay an extra $20 an ounce to have unlimited downside protection until Jan 28, 2008? That is exactly what the above example proposes (depending upon your outlook the ounces purchased versus ounces hedged can be tinkered with, longer option duration’s can be purchased, high/lower strikes, etc.)
A lot of people who rushed into gold the last time $800 was busted were quickly handed their heads. While there is little reason to expect a repeat of the 80s price collapse today, investors that chase the price of gold higher could be well served by considering a hedging approach (or ‘straddle’ like strategy). At a time when ‘dollar doomed so buy gold’! abounds, it is as least worth considering a topic no one wants to discuss.
For the record, I continue to own physical, unhedged precious metals. On a record setting rally I would consider selling more gold and/or acquiring some downside protection. |
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