Thursday, September 30, 2010

How To Short Gold "Safely"

When the cost of a commodity is well below its asking price, something is amiss. Such is the case with gold, as major producers are able to dig it out of the ground for around $500, and sell it for $1300 (and rising). This has encouraged majors like Barrick, Newmont, and Goldcorp to increase production and increase exploration. As a result, they have about 15-20 years (and rising) worth of proven reserves left at current production rates. As the price of gold continues to rise, that process will accelerate, increasing supplies.

On the demand side, sentiment is raging bullish, as discussed here. (For an additional example, consider the wildly positive comments towards gold on any Seeking Alpha article on the subject.) As contrarian investors know, when the investment world is bullish on a security, the price is soon headed in the opposite direction.

But for the long-term investor, it's impossible to know when that will happen. Perhaps some owners of gold will decide to sell at the same moment, causing a panic. Perhaps economic data will turn positive, and increase the likelihood of rate hikes, sending investors out of securities that earn no interest. Whatever the case may be, however, it could take years to happen.

Yet, those who wish to short gold often do so with puts. But puts expire, and since the long-term investor does not know when gold is going to head back to normal space, this is a dangerous game to play - even with LEAPS puts. Of course, one could buy a series of LEAPS puts, staggered several years out, but such a position can become expensive for the retail investor.

Going short physical gold or a gold fund is also a common option. But should gold's run continue or even accelerate, the investor is subject to margin calls and to principal loss. This may be perfectly fine for a trader looking to time the gold decrease, but is not suitable for the long-term investor who wishes to avoid the risk of losing his entire principal before the price drop occurs.

The best option for such an investor may be the purchase of an ETF that is short gold (using puts, derivatives etc). There are three commonly used ETF/ETNs of this nature, including DGZ, DZZ and GLL. The benefit here is that even if gold rises to astronomical heights and takes many years before it comes back down to a reasonable level, it is not likely that the investor will have lost his entire investment. The reason for this is that as gold rises, the positions of these ETFs are adjusted so that each percentage move in gold results in a similar percentage move (in the opposite direction) in the ETF. DGZ and DZZ are adjusted monthly, while GLL is adjusted daily. The retail investor would experience much in the way of transaction costs were he to construct a short position and attempt to re-adjust its size daily.

One thing to watch out for, however, is that DZZ and GLL attempt to double the percentage change in gold (in the opposite direction). For example, if gold rises 5%, DGZ is likely to fall 10%. As such, a 50% move in gold in a single month (for DGZ) or a single day (for GLL) will wipe out the investor's entire position. This is unlikely, especially for GLL which is adjusted daily, but not impossible, particularly if bubble frenzy catches fire at some point. There are also other risks involved with these ETFs, so investors should be sure to have read and understood the fund prospectus before making a decision.

Once the decision is made to choose one of these short ETFs, it also becomes a difficult task to determine when to sell. While value investors may agree the current price of gold is higher than it should be (due to the wide difference between production costs and price), it's difficult to know exactly what the price should be. This inability to determine a sell point is another challenge when it comes to shorting gold, though one that is not all that unfamiliar to value investors. (e.g. Sometimes one can tell that a stock is undervalued, even though one can't put a number on its exact worth.)

Bubbles can take years to pop. As such, many who are not gold bulls choose to sit on the sidelines rather than risk their capital going short. For those who are willing to wait years (if necessary) and who understand the fact that the price of gold could rise substantially in the interim, going long a short ETF may be a better option.

Disclosure: None


tscott said...

Great article! It is really tough trying to figure out when to short gold or if I should avoid the area completely. Personally, I am not interested until it reaches a new all time inflation adjusted high which appears to be $2250. This is in the too hard pile for now.

Anonymous said...

Great write-up. I have not seen anything like this presented anywhere...Thank you.

Anonymous said...

If you cannot justify ever going long gold,
how can you justify going short? Illogical.
Especially since history has clearly shown
that gold has gone to irrational heights. And
going long a short ETF can lead to a total loss.
Logically, there is no way a short ETF can
mathematically protect against a massive
rally in gold. I think you should accept gold
is outside your circle of competence and stay

Paul said...

And some people still don't think we're experiencing a bit of irrational exuberance?

Eric said...

I think you're missing the point. Saj is providing a creative way for a small retail investor to speculate that gold is overvalued, *without* risking an infinite loss should gold continue to climb. At worse, an investor risks the loss of principle, and doesn't face the need for margin calls, or as he stated, expensive transaction fees to regularly adjust one's position.

Saj, great and unique viewpoint.. thanks!

Ross said...

This is a great piece, just what I was looking for. Now I have to find some gold short ETFs in the UK - or take the admin fees of dealing with US stocks.

Ross said...

You could hedge this by going long on all other metal/commodity ETFs, of course.

Anonymous said...


Anonymous said...


Given your observation that the gap between gold production cost and gold asking price is very large, wouldn't it make more sense to arbitrage those two factors rather than simply shorting gold? In other words, how about going long a basket of gold producer stocks (with an ETF) and also shorting gold? That way you don't need to speculate on the future price of gold.


Saj Karsan said...

Hi aagold,

I'm not sure how that would work, as gold price increases go right to the producers' bottom lines. So if the price of gold drops to production costs, the short makes money but the long position loses money, so what have you gained?

Assaf Nathan said...

I believe you got it wrong,

DGZ is NOT inverse double the price of gold, but DZZ.

DGZ is the simple inverse, while DZZ is the double inverse.

Saj Karsan said...

Thanks Assaf, I have now corrected it.

Bala said...

Arent the ETF's you have identified are leveraged ETFs,

If so, then isnt the inherent issue with leveraged ETf's is that you lose if you are long term on them.

Anonymous said...

Hello, I am a novice investor and found this article to be quite interesting and educational. In reading elsewhere I came across an article that discussed using the other alternatives to ETFs because they suffer from "leveraged ETF decay". Could you comment on your thoughts to the decay as well as better tax incentives for the other options (puts, etc)? Thanks.

Saj Karsan said...

Hi Anon,

Yes I do agree about decay. Regarding taxes, however, that will depend on your jurisdiction.