How to Short Gold…If You Dare

by ETF Base on October 13, 2010

With the price of gold hitting new highs seemingly daily, one would have to be rather daring to swim against the tide.  But if you’re looking to take up a contrarian position against continued gold price increases, there are a few ways you could do so.  First, let’s look at what’s driving the current price action.

What’s Driving Gold Prices?

  • Inflation? Historically, people flocked to gold as an inflation hedge.  Since the value of a dollar (or whatever the local currency is) was losing value in the marketplace, gold was attractive as an anchor currency – a hard asset.  In times of inflation, hard assets like real estate and precious metals increase since their supply is viewed as finite while governments can manipulate currencies to either tame or stoke inflation (given enough time).  This time’s different though.  We are not in a period of inflation.  In fact, we may very well be looking at deflation (examples of deflation investments).
  • Fiat Currency Collapse – No, rather than the specter of hyperinflation driving gold this time around, many attribute the rise in price to a virtual race to the bottom in all currencies.  As governments around the world continue to print more currency to stimulate their economies, the fiat currency model is becoming suspect to the point that people are beginning to lose faith in the true value of their local currency.  Gold is now being viewed as a virtual currency replacement – something that the government can’t simply flip a switch and produce more of.
  • Bubble? – Humans find a good bubble too hard to resist.  From tulips to internet stocks to real estate propped up by liar loans, when it starts to look like easy money is being made and you’re left out, the urge to jump on board is often too much to resist.  For the first time in decades, late night infomercials, radio ads and even respected talk shows are now touting the benefits and safety of gold, with people even setting up Gold IRAs. This was unheard of when gold was at $300/ounce, but one cannot help but notice the current frenzy.  After all, it’s the only asset besides bonds (see how to short bonds too) that’s performed well over the prior decade.

Why Gold Prices Could Fall

  • Correction – Even during periods of bubble formation, assets do decline temporarily, and then they drop precipitously in the end.  Given the pause in the $1000-$1100 range previously and then the rapid ascent to $1370, it’s entirely plausible that gold prices have gotten ahead of themselves and could fall an easy 10% – 20% within a couple months.  After all, the financial system didn’t collapse and Europe didn’t implode.  In fact, the Euro is now rallying against the US dollar – which is good for commodity prices in terms of the USD, but also assures us the world is not coming to an end.
  • Politics – Not to get all political on you, but many view the current administration as somewhat loose with the budget and fear further massive entitlement programs and stimulus packages which would further weaken the US dollar and add to the $13.5 Trillion deficit.  If we get a reversal in momentum at the mid-term elections and Democrats lose their majority, there will be gridlock in Washington with a right-leaning Congress.  Gridlock is often good for stocks and may not be so good for spending programs which would require cooperation amongst the House, Senate and Obama.

How to Short Gold

  • Basic Approach: Short (GLD) – GLD is the most popular gold ETF with plenty of volume and a small bid/ask spread.  By shorting shares, you’d benefit from a downside move.  Note however that this opens you up to unlimited losses and if gold really spikes, this could be a dangerous trade.  Precious metals trading can be both rewarding and risky, so hedge accordingly.
  • Basic Approach #2: Long PowerShares DB Gold Short ETN (DGZ) – DGZ would be a means to limit your losses by buying the inverse and benefitting from a decline.  ETNs have some risks including issuer solvency risk and futures roll losses (see ETF 7 Deadly Sins for more on what to watch for).  There is no inverse ETF though, so this may be your only choice for a loss-capped 1X approach.
  • Buy Inverse ETF: Long (GLL) – This ETF seeks to replicate 2X the inverse return of gold daily.  This would amplify both your gains and losses.  Note however that leveeraged ETFs tend to lose value over time regardless of the underlying asset performance due to daily resets.
  • Naked Calls: Sell Out of Money Calls on GLD – This is also a risky strategy, but a means to capture some option premium on a rolling basis if you believe gold won’t breach the strike price you choose.  If GLD is at $134 and you sell a call for $140, as long as GLD doesn’t breach $140 by expiry, that option expires worthless and you keep the premium.  It’s risky though, as your losses are unlimited should GLD exceed the strike.
  • Naked Puts: Buy Out of Money Puts on GLD – This is an option to benefit from a drop in gold prices while limiting your loss.  With GLD at $134, you can buy a put option at 130 strike, Dec expiry for around $3 premium (at a cost of $300 for the contract of 100 shares).  Therefore, if GLD drops below $127 by expiry, it’s all profit from there and you’d have capped your loss at $300.
  • Pairs Trade: A nifty trend to watch for is when the premium on the Sprott Physical Gold ETF (PHYS) gets ahead of historical norms and you can simultaneously short PHYS while going long GLD.  See my recent gold pairs trade result, which was the best risk/return money I’ve made in a long time.

Bear in mind that most options expire worthless, leveraged ETFs lose value over time and opening yourself up to unlimited risk can be catastrophic.  Additionally, different methods have different tax liabilities (see gold taxes for differentiation).  But these are some avaialable tools nonethless.  I make no predictions on where gold is headed from here but I do own a small portion of my trading portfolio (full portfolio holdings/performance) due to the trend, hedging, and belief the we may see further currency devaluations for years to come.  Should you decide to go with the drain and go all-in on the gold trend, there are actually some ETFs beating gold worth a look – silver, platinum and others that have industrial utility as well.

Disclosure: Long GLD.

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