How to Maintain Long Term Exposure to Gold on a Budget
Only one investment has held a special place in the minds of investors for thousands of years. That is gold. The yellow metal was important in ancient cultures, sparked journeys to new worlds and is believed to offer protection against catastrophe.
Gold has been available to investors as coins and bars for thousands of years. It’s been used in jewelry for adornment and investment for thousands of years. In more recent years, investors have had access to gold in the form of exchange traded funds (ETFs) and other pieces of paper that represent gold.
Some investors believe the stock of gold miners provides them with exposure to gold. In an indirect way, it does. But, in a direct way gold mining stocks provide exposure to mining companies. The stocks are subject to the risks of any company including failures of management to navigate the current business environment.
The difference between gold and gold miners is shown in the chart below. Changes in the value of gold are shown as the black line. Gold mining stocks, in this case, VanEck Vectors Gold Miners ETF (NYSE: GDX) is shown as the blue line. The red line shows the performance of smaller mining companies represented by VanEck Vectors Junior Gold Miners ETF (NYSE: GDXJ).
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Miners show more volatility than the price of gold, which is represented by SPDR Gold Shares (NYSE: GLD) in the chart. Small companies have underperformed the metal by a wide margin. The combination of high volatility and poor performance should be avoided by investors.
The chart above shows a short term view of performance, just the last three months. The next chart shows the long term performance of the three assets.
In the long run, in this case a period of more than six years, mining stocks have significantly underperformed GLD. This will not always be the case as the next chart shows. Over the past 20 months, miners have beaten gold.
Investors Need Defined Objectives
As the three charts above show, investments deliver different results over different time frames. Because of that, investors need to define their objective for the trade before they place a buy order.
If an investor wants exposure to gold, they should most likely buy gold. If they have a specific reason to believe that gold miners will outperform gold in the short run, they should buy miners. But, as the charts demonstrate, mining stocks will not always be a proxy for owning gold.
Investors have always owned gold for different reasons. They may want to acquire gold as protection against inflation. In this case, they might want gold coins to have available if inflation does spike suddenly.
Some simply trade gold looking for short term price moves. These investors often use future contracts to obtain leverage. Futures also provide the ability to trade gold on both the long and short side.
Let’s look at each of those features in turn.
Leverage allows an investor to increase their exposure to an asset with limited funds. In the futures market, leverage is obtained through the use of a margin deposit. In the futures market, an investor is able to control 100 ounces of gold for a margin deposit of just $3,950. Individual brokers may charge higher amounts.
At the recent price of about $1,170 an ounce, 100 ounces of gold would cost $117,000. Futures allow investors to benefit from an investment of that size by putting up just 3.4% of that amount.
Futures traders can buy the contract if they believe prices will rise. They can also sell the contract short if they believe the price of gold will fall. Either a long or short trade requires the same amount of margin. With that small amount of margin, traders can benefit from moves in either direction as long as their forecast is correct.
While futures provide pure exposure to gold, miners provide exposure to the metal and the management of the company. When buying a miner, the trader does obtain, at least to a degree, leveraged exposure to the price of the metal.
But buying a miner carries more risks than gold. The mining company may carry a large amount of debt. Investors are counting on management to manage that debt. The company also has risks associated with political changes if the mine is located in a foreign country and labor strife no matter where they are located.
Accidents can happen in mines and that would affect the price of the mining stock, no matter what happens to the price of the metal. There are other unique risks associated with each mining company and investing in the sector can require specialized knowledge.
Options Offer an Alternative to Futures
Leverage and the ability to benefit from up or down moves are advantages of futures. But, not every investor has a futures account. These markets are probably not available to most investors. But options on ETFs are available to many investors.
An option provides leverage just like a futures contract. But, the advantage of an option is that risk is limited. When buying an option, you can never lose more than the amount you paid to buy the option. This is not true in futures where buyers face the possibility of almost unlimited losses.
Options can also be used to benefit from price moves in either direction. The buyer of a call option benefits from a price increase. To benefit from a price decline, an options trader can buy a put option.
Options can be more expensive than futures. Options are available with various exercise prices and with various time to expiration. This creates opportunities to implement almost any market opinion.
For example, an investor might be bullish on gold in the long run. There is an option on GLD expiring in January 2019 that allows an investor to obtain long term exposure to the metal.
A deep out of the money call option will behave almost exactly like the price of gold. The price of these options will rise about $1 when the price of gold increases by $1 and they will fall about $1 when the price of gold declines by $1.
There is a January 2019 call option with an exercise price of $60 that could be used for this strategy. This option is trading at $57.57. Since each contract covers 100 shares, the option would cost $6,000 to purchase.
If GLD is above $120 at expiration, the option would be worth at least $60. If GLD is below $60 at expiration, this option would be worth nothing. At prices in between those extremes, the call would be worth the difference between the market price of the ETF and the strike price of the call.
With GLD at $90, the call would be worth $30 and the loss would be $3,000, the difference between the price of the call and the $90 value of GLD This would be about the same loss an investor in GLD would experience.
The deep in the money call is a proxy for stock or ETF ownership. But, these options are expensive.
A $120 January 2019 call is also available. This option costs about $8 or $800 per contract. It is profitable as long as GLD is above $128.20 at expiration and the potential loss is capped at $800.
A cheaper option, the $140 January 2019 call is trading at $2.68 and costs $268 per contract. This could be the best option for an inflation hedge. It is relatively low cost and if inflation pushes gold to its old highs near $2,000 an ounce, the call would be worth $60, a 2,000% return on investment.
Gold has long had a hold on investors. Options on GLD finally allow small investors to control relatively large investments in the metal with limited risk.