Get Positioned for Gold’s Comeback Now
One of the most important points in the curriculum for the Chartered Financial Analyst (CFA) designation is diversification across asset classes. More than stock picking or top-down economic analysis, analysts are taught to take advantage of all asset classes to produce risk-adjusted returns for clients.
It’s a sound strategy, but one that runs up against problems when you start adding commodities to a portfolio. While assets such as stocks, bonds and real estate all produce cash returns through interest and dividends, investments in commodities offer no returns until you sell them.
Sure, mining companies may pay dividends, but that adds company-specific risks to the portfolio. Meanwhile, share prices may move more closely with the stock market than with actual commodity prices.
The good news is that one simple strategy lets traders produce immediate cash returns on commodities. And as the stock market wobbles heading into 2016 and higher interest rates threaten the business cycle, several signs point to this being a good time to invest in gold.
Gold Bugs May Soon be Rewarded
After more than three years of falling prices, there is reason to believe gold could make a comeback.
First, for many investors, gold provides security when stock market volatility increases. The recent market sell-off has brought another spike in the Volatility S&P 500 (VIX). While the price of gold hasn’t risen in tandem yet, fear of a deeper market correction may send investors running for safety.
Next, the World Gold Council reported global investor demand jumped 27% year over year in the third quarter. In the United States, demand for physical gold bars and coins rose to the highest level in five years, surging 207%.
Central banks have also been aggressively buying the yellow metal with 19 consecutive months as net buyers of gold for reserves. The stronger U.S. dollar has held back the price of gold, but it’s also driven central bank buying as monetary authorities get positioned in hard assets against weakness in their own currencies.
Even consumers have jumped back into gold with double-digit increases in demand across all regions in the third quarter.
Sentiment is clearly turning in gold’s favor and higher prices should follow.
Strength in gold prices should send mining stocks higher, but there is still a lot of company-specific risk in the industry. Many gold miners are still working through massive amounts of debt with an industry average debt-to-equity ratio of 59%, and the average profit margin stands at -18.9. Even with an increase in prices, some companies may find their debt load unsustainable. For others, it could take years to return to profitability.
Monetize Your Gold Position Immediately
Fortunately, one of my favorite option strategies allows me to monetize an opinion on gold prices without having to wait until I sell the investment. In fact, I may get paid without having to take a position at all.
Selling put options on the SPDR Gold Shares (NYSE: GLD) means I collect a cash premium now and agree to buy the shares if they fall to a certain price (the strike price) by a certain date (the expiration date). If the price of GLD is above the strike price at expiration, I keep the cash premium and do nothing. If GLD is below the option’s strike on expiration, I buy the shares at a discounted price.
Some traders shy away from put selling, but that is a big mistake. Even relatively inexperienced traders can make a lot of money with it.
In fact, we just created a video that shows how our 32-year-old customer service rep — who has no real trading experience — made $274 in two minutes. Before you make up your mind about selling puts, please watch this.
GLD is physically backed by gold so shares trade alongside gold prices. The fund is extremely liquid and the bid-ask spread on option contracts are tight.
With shares of GLD trading for $101.52 at the time of this writing, we can sell the GLD Jan 103 Puts for a limit price of $2.75 each ($275 per contract).
If GLD closes below the $103 strike price at expiration on Jan. 15, we will be assigned shares at that price. Since we received $2.75 in options premium, our actual cost basis is $100.25 per share — a 1.3% discount to the current price. The fund hasn’t closed below $100 since 2009 and was as high as $125 at the beginning of the year.
However, we want to make sure we have enough money in our account to cover this potential obligation. This means setting aside an additional $10,025 for every put contract we sell — $10,300 for 100 shares minus the $275 we collected for selling the puts.
If GLD is above $103 on expiration, which is just 1.5% above the current price, we keep the premium for a 2.7% return in 31 days. This works out to an annualized return of 32%.
Gold prices likely won’t hit the highs of 2011 for many years to come, but we don’t need runaway prices to book solid gains. Investors are starting to come back to the metal and central bank buying should support prices even if the dollar continues to gain.
Don’t neglect a strong piece of the portfolio puzzle for lack of cash returns. Diversify with an investment in gold while collecting income on the position.
Note: Earlier I mentioned how our customer service rep — a trading newbie — used this strategy to pocket $274 in two minutes. After three years of listening to customers rave about how much money they were making — $800, $2,000, even $5,700 or more every month — she had to try it. Watch this video to see how easy it is.