Thursday, December 14

Income From Gold

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Gold is not an investment, because it doesn’t generate any income – no interest and no dividends. Potential price appreciation doesn’t count because the price could just as easily fall. Gold is only an investment for the fearful and those who are too dumb to notice that their gold is not writing them any checks.

If you own gold (or silver); and if you believe it to be a valid way to diversify your portfolio, you have probably heard that conventional wisdom.

As is often the case, the conventional wisdom is wrong. Dead and completely wrong. In the past, the small investor could not earn income from gold. Now, you can earn income from your gold holdings. Whether you own bullion coins, collectible coins, 400 ounce bars or even paper gold – you can (and should) put your gold to work. Here’s why.

Gold has Price Risk

Gold owners are usually conservative folks. If the price of gold drops they aren’t going to sell their holdings because gold is suddenly a bad investment. They take “buy and hold” to a brand new level – because they understand that gold is a store of value.

But like any other asset, gold prices fluctuate. The current 10 year bull market in gold was preceded by a 20+ year bear market. If you bought bullion in 1980 and had to cash out in 2000, you took a beating. That’s price risk.

Price risk, like most things in life, can be sold. Speculators are eager to bet against the price of gold rising by buying your price risk – whether gold is currently rising or not. They pay cash for your risk. And it’s easy to find speculators.

Futures, Speculators and that Dirty Word: Hedging

The futures markets exist to transfer price risk. If you own gold – or any other asset – you have price risk, which you’re free to ignore. You can buy and hold gold and tough out a 20 year bear market, if you like. Or, you can buy and hold it smarter by selling that risk to speculators via the futures market.

Anything you do to diminish your price risk is, by definition, hedging. Hedging is a dirty word to many investors. That’s probably due to a basic misunderstanding of how hedging works. There are two basic approaches.

A straight, conventional hedge simply attempts to completely neutralize price risk. If you own 100 ounces of gold you are long gold, with lots of risk. You can almost exactly neutralize your risk by going short a 100 ounce gold futures contract. As the price fluctuates, the two positions gain and lose in exact opposition to each other. You own gold and its price can never change. Super conservative, but no income.

The other approach is known by various names: delta hedging, dynamic hedging or covered call selling – similar to what many investors do every day in their stock portfolios. Sell a call against the approximate value of your gold and if the market price doesn’t exceed the strike price of the call by expiration: hello income.

How much Income is Possible and what are the Risks?

Currently, a call with a roughly 70% probability of expiring worthless would return about 11% – in two months. This is a fairly typical rate of return for this type of trade. Compared to the current interest rate environment of 1-2% annual returns the difference is striking. When you further consider that you receive this potentially outlandish return to decrease your overall risk, the decision to execute seems automatic.

It’s important to emphasize and understand that both hedging approaches decrease overall risk – assuming they are properly managed. A common objection to selling calls against long position risk is that the short call caps the potential price gain on the underlying gold. This need not be a problem. Any good option trader will be able to show you how to maintain unlimited potential on the underlying asset.

Don’t try this at Home – Yet

Talk to a futures broker before attempting this trade if you are not experienced with options or futures in general. There are margin and expiration details beyond the scope of this article.

And next time you hear someone say that gold can’t return cash – tell them they’re mistaken.

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