Why You Should Consider Hedging if You Own Gold

Golden fleeced

The FT's Lex Column on Wednesday ("Golden Fleeced") offered a reason why gold may have further room to run, but also a caution for current gold investors.

Room to run?

Lex noted that despite its current, nominal highs, adjusted for inflation, gold is still 30% below its 1980 peak.

A note of caution

Despite the potential room for gold to run, Lex pointed raised this red flag:

One classic warning of a peak – a rush of what professionals call dumb money – is already evident. Look at iShares’ gold trust IAU, which holds 12m ounces. It has seen a disproportionate rise in small buyers: the number of accounts with fewer than 1,000 shares (100 ounces) has trebled in the past year while large ones have barely budged.

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The rush for the exits, whenever it comes, will be lively.

Being hedged means not having to rush for the exits

If you own gold, and you're hedged, you can find out how much more room gold has to run, confident that your downside in the face of a major correction will be limited.

1980 vs. 2008

If you're hedged when the next correction in gold hits, you'll have the breathing room to consider whether that correction is analogous to 1980's crash from gold's generational peak or to 2008's sharp, though temporary, correction.

Remember that in 2008 gold fell to a low of $712.50 per ounce, after having peaked at over $1,011 per ounce earlier in the year. A gold investor who had been hedged could have, if he were still bullish on gold at that point, sold his hedges and used the proceeds to increase his position in gold.

A step by step example of hedging with optimal puts

Below we've demonstrated a way to hedge gold, using optimal puts on the SPDR Gold Trust ETF (GLD) as a proxy for it. First a quick reminder about what optimal puts means in this context.

About optimal puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (availableon the web and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Step 1: Enter a ticker symbol

In this case, we're using GLD as a proxy, so we've entered it in the "Ticker Symbol" field below.

(Click to enlarge)

Step 2: Enter a number of shares

For the purposes of this example, let's assume the investor has a $100k in physical gold or other gold assets. Since we're using GLD as a proxy, the number of shares we'll enter will be $100,000 / the most recent share price of GLD ($161.49, as of Wednesday's close) = 619.23. We've rounded that down to 619 and entered that number in the "Shares Owned" field in the screen cap below.

Step 3: Enter a decline threshold

You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. So we've entered 20% in the Threshold field in the screen cap below.

Step 4: Click the red button

A moment after clicking the red button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge 612 shares of GLD against a >20% drop between now and March 16, 2012. The cost of this protection on a $100,000 position would be $942, or about 0.95% of the position value. Two notes about these optimal put options and their cost:

• Portfolio Armor rounded down the number of shares of GLD we entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then presented us with 6 of the put option contracts that would slightly over-hedge the 600 shares of GLD they cover, so that the total value of the 612 shares of GLD would be protected against a greater-than-20% decline.

• To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.