RSSDid You Hedge Your Gold Stocks?
By Brad Zigler | October 03, 2008 | 12:28 PM | 0 Comments
Gold and other precious metals got whacked Thursday along with the thumping taken by equities. And that was the recipe for a real bruise-up in gold mining stocks. The gold/stock ratio, measured by the prices of SPDR Gold Shares (NYSE: GLD) and the Market Vectors Gold Miners ETF (NYSE: GDX), reached a record high 2.84-to-1 by yesterday's close.
Yesterday's price action makes gold a breakeven proposition for the year to date, while the three dozen issues held by the mining fund have collectively fallen 37%.
Gold (GLD)/Mining Stock (GDX) Ratio
McMillan's Option Trade
The rising ratio has made trash of option guru Larry McMillan's August strategy outlined in "Options As A Golden Opportunity." The play, entailing the simultaneous purchase of GDX calls and GLD puts, banked on the ratio reversing its summer stair-step ascent. McMillan's clients would have been stopped out of the GLD puts on September 15 for a scratch trade, leaving the GDX calls now worth about half their initial value.
Hedging the Hedge
When I spoke to mining stock investors at the New York Hard Assets Conference in May, I presented a buying technique (see "Hedging Gold's Volatility") that allows an investor to capture the excess return produced by a mining company's management while hedging against adverse moves in the gold market.
The tactic pairs a gold mining stock or fund purchase with an investment in the PowerShares DB Gold Double Short ETN (NYSE: DZZ). Owning the pair gives the investor her own mini hedge fund, allowing whatever talent the target companies possess to shine without being dulled by a poor metal market.
Now's probably a good time to revisit the tactic to see how it's fared since the conference.
Leading up to the conference presentation on May 12, the hedge ratio - that is, the factor that determines the number of DZZ notes necessary to hedge embedded gold risk - for the GDX portfolio was .83. Post-conference, the hedge ratio rose to .90, indicating increasing volatility in gold mining shares. In a dynamically adjusted hedge strategy, that increase would have required additional purchases of DZZ notes to maintain full hedge protection.
Since May 12, GDX lost 34%, while DZZ gained 9%. So, pound for pound, a DZZ investment would have mitigated some, but not all, of the loss sustained by owning the miner ETF. Maintaining the original .83 ratio, a hedged investment in GDX made on May 12 would have lost 16% by October 2, less than half the unhedged decline. The hedged position's volatility was also half that of a naked fund holding.
There's a lesson to be learned here. The financial meltdown that ensued after the conference introduced more-than-historic volatility to the gold and equities markets. The increase in the hedge ratio is testimony to that.
If you use DZZ as a hedge overlay in expectation of a significant event, "overhedging" - that is, utilizing a larger DZZ position than that implied by the historic hedge ratio - may be needed to provide full insurance. Otherwise, you can adjust the size of the DZZ overlay in piecemeal fashion - increasing it with upticks in the hedge ratio and decreasing it with declines - as you go along.
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