Friday, September 30, 2011

Shorting 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 $1600. 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 (the last week or so aside), as discussed here. 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 this recent slide will be a turning point. But perhaps it won't. At some point sooner or later, 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: No position


Christian said...

Maybe I've missed something, but inverse long & short ETFs suffer from very serious tracking errors—something David Dreman among others have written about—so this is only a good strategy in theory.

In reality the ETFs don't track the index at all over longer periods. Gold might go up 100% in a year, but the ETF is up something completely different, say 50%.

This strategy might work over a short period, say one week, not years or months.

Konrad said...

I usually like your posts, but this one makes some statements that should be treated very carefully. You advise people to go long short-gold-ETFs because:

"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."

that is simply wrong especially over longer periods where the deviation can become quite significant. when gold drops 10% in a day the short etf will gain 10%, which is not the same as to what a short position would generate (11%). These small differnce can accumulate to generate very large differences over time, in particula with an asset as volatile as Gold. In fact gold may be lower in a year but your short etf has still lost value!