Gold And Inflation: Countering With An Options Strategy

By Mark Whistler | September 10, 2007 AAA

Gold's on the move, and it's starting to show up in headlines again.

Some of the recent move can be attributed to a pre-September 11 flight to quality, just in case an anniversary terrorist attack was in the works.

However, the near-term picture for gold is brighter than ever, with the U.S. economy still in uncertain waters due to to the subprime debacle. Should the Fed hold off on lowering rates, or not cut enough to please bulls, gold could easily find another spike higher.

And that's where a prudent analysis of gold comes in. Instead of an all-out investment in gold, think of it more along the lines as a partial portfolio hedge.

By putting a small amount of gold in your portfolio, not only are you diversifying, but you're also protecting yourself against an unforeseen move downward in the major stock indexes and against inflation risk. Call it good housekeeping, if you will.

The Misleading Tide of Inflation
Up until 1971,gold really hadn't kept up with inflation. In the 1930s it did, but only because the government forced U.S. citizens to sell their gold and then adjusted the price upward.

Then in 1971 President Nixon ended the gold standard. Nixon's move was intended to allow the price of gold to move freely, hopefully keeping up with inflation. But over the years, it just hasn't worked out that way. Statistics from InflationData.com show that from gold's price peak in the 1980s, cumulative inflation rose, while the price of gold declined. When looking at the price of gold in context of inflation-adjusted dollars, since the early 1980s, gold should actually be trading somewhere around $1,600 to $2,000 a troy ounce. But, as we all know, it's far from it. The facts are plain and simple.

Reality Bites And Gold Jumps
People buy gold when they're feeling fearful of a war, economic losses, or political unrest. Yes there are modern consumption factors and production shortages playing into the cards, but throughout history, every gold spike can be mirrored with one of the three aforementioned fear-based factors.

In 1979, when gold spiked to over $800 a troy ounce, the event can be matched with the KGB/Soviet debacle in Kabul, Afghanistan. With the cold war in place, many feared for the worst and gold rose accordingly. In the mid 1980s gold rose with the Iran-Contra Affair. In the early 1990s, gold made a small spike with the first Gulf War. And presently, gold has been on the move ever since the September 11 attacks.

Thus, when we simply step back from the situation, we see that gold is really more of a "fear hedge" than an inflation hedge.

What's Up Now?
As I previously mentioned, gold is on the move again. The obvious fear-factors playing into the move now are:
1. The Iraq War
2. Al-Qaeda remains a threat and things are still rocky in Afghanistan
3. The U.S. is in the midst of a potential subprime bombshell

But there's one more factor out there to consider: China.

At present, China has over $1 trillion in foreign currency reserves, and it has made it clear that it hopes to slowly back out of U.S. Treasuries. So, where will it put some of the money? You guessed it: gold. It's a new factor that could create a paradigm shift in the traditional U.S.-based precious metal fear-factors. This time, China's on the other side of the coin.

While there's no guarantee that gold will move higher, the bullish case can't be completely overlooked. But the question is, how to safely play gold, given that resolution of the subprime issues, or the Iraq debate could cause the price to dive, even with China in the picture. The answer is an option play. (To learn more, see Using Options Instead Of Equity.)

Buy Low, Sell High
In the world of options, you may have heard of covered calls. The strategy is where an investor buys the stock outright and then sells a call against the stock. Thus, if the stock is called away, the option writer's risk is limited. In the case of gold though, those who believe that gold will rise, but at the same time, are worried about holding gold stock, can implement an in-the-money covered call. Yes, the gains will be limited, but in some cases they could top 20% or more in a matter of months. Here's how it works.

First, you need to find an company that you believe in. A few to look at in the industry include, but are not limited to, Newmont Mining (NYSE:NEM), Royal Gold (NYSE:RGLD), Goldcorp (NYSE:GG) and Seabridge Gold (NYSE:SA). Then, you should scan the option chain to find an in the money option with a significant amount of premium attached.

Let's assume a stock is trading for $50 and the December $45 call is trading for $10 on the bid. Assuming we bought the stock for $50 and sold the call for $10, we would need then need to find our cost basis. This is done by simply taking the premium we received for selling the call ($10) and subtracting it from the present stock price ($50), giving us our cost basis of $40.

Since the stock is already trading in-the-money, it's likely that our shares will be called away when the options expire in November. But we still profit. We will have made $5 on the trade, denoted as the strike of $45 minus $40. Then when we divide the $5 by our cost for $40, we see our return would be 12.5%. Not too bad for four months, and on an annualized basis the return would be 37.5%. Where else are you going to make that type of money? (For a detailed look at in-the-money covered calls, check out An Alternative Covered Call Options Trading Strategy.)

But there's more to the story. We've also protected ourselves on the downside. The stock would have to fall below $40 before we would ever be negative in the trade, thus becoming outright owners of the stock at expiration. And given that the aforementioned event would require a $10 drop from $50, the stock would have to lose 20% of its value before we were ever in the red. At the end of the day, we enable ourselves to potentially purchase the shares at a 20% discount to the market price.

Finally, the strategy works very well with long term options, known as LEAPs, too. By writing in-the-money LEAP covered calls, we are able to take a long-term position in a stock, while building in plenty of downside risk to our trade. On that note, it's important to note that options are risky and if you are considering trading them, you should absolutely speak with your local finance professional first to make sure you level of market knowledge and financial well being are adequate for the risks involved.

To learn more, check out Using LEAPS In A Covered Call Write.

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