HardAssetsInvestor

Written by Brad Zigler  |

July 23, 2009

What To Do About ‘What-If’ Gold

Details

What investors can do to protect themselves should a deflationary spiral kick in and they've been hoarding gold ...

• The effect on the key jewelry segment
• Do fundamentals take a back seat in the gold market?
• The insurance role of LEAPS

 

The diverse array of experts interviewed by Hard Assets Investor (HAI, HardAssetsInvestor.com), together with our opinion pieces, is virtually guaranteed to perturb some of our readers while pleasing others. And no single subject causes more fur to fly than gold.

In particular, prognostications for gold prices seem to stir up a lot of emotions, and at any given time, gold bears get the worst of it from readers. Yet there are times when a sell-off ought to be reasonably expected or even welcomed. Sometimes, a commentator or interviewee merely espouses a bearish gold view as a counterpoint within a balanced examination of the market.

Consider our recent take on the prospects for inflation ("Laying Odds On Inflation"). Through trend analysis, we attempted to put numbers to the predictions for runaway inflation as well as for a deflationary spiral.

Arguments for an inflationary setup abound, but the deflationary scenario often gets short shrift. In the article, we calculated the chances of a rather modest one-standard-deviation decline in monetary inflation - or seeing the index drop from the 152 level to 136 - sometime within the next 500 days at 43%. Two-for-five odds - not an insubstantial probability.

In such a situation, the accompanying decline in gold's price could be significant, since our measure of monetary inflation is, in large part, based upon the dollar's gold purchasing power. Such a decline in fact, is anticipated by some chart watchers who've been looking at gold's recent trading pattern and see the potential for a big breakdown.

How big?

 

The Case For Lower Gold

Well, consider that the spot COMEX contract closed atop $1,001 in February, only to slide to the $867 level in April. Attempts to make new highs have twice failed, leading the technically minded to think that a breakthrough move below April's low could ensue, as a setup for a test at $733.

There are, as well, fundamental arguments for lower gold prices, such as those discussed in our May interview with Heraeus Precious Metals Management Vice President Miguel Perez-Santalla. He called for a short-term sell-off, saying, "I could see gold in December coming down to around $700."

A sell-off wouldn't necessarily inflict fatal damage to gold's long-term trend. If anything, it might even be considered healthy, since it would drive fresh buying from the key jewelry segment, according to Perez-Santalla. A decline to $805 in the spot COMEX contract would retrace about two-thirds of gold's November-February run-up, which could be a good place for a rally.

Failure there, however, could inspire aggressive technical selling. After all, the base for the fall 2008 rally was $681, perilously close to Perez-Santalla's $700 objective. Downside excursions testing the base could very well inflame bearish sentiment.

In particular, traders who view the last 16 months of gold market action as a consolidation top see a downside objective of $357 - a level not traded since 2003 - for the nearby COMEX contract, should the 2008 base be breached.

Present-day fundamentals may not seem to sync with such a drastic sell-off, but we know from past experience that fundamentals often take a back seat in the gold market, at least for a time.

 

Protecting Your Gold With LEAPS

So ... what if? What if a big break in gold does materialize? What insurance can protect you if you've been building a gold hoard?

Enter LEAPS-or Long-Term Equity AnticiPation Securities - on the SPDR Gold Shares Trust (NYSE Arca: GLD). LEAPS, most particularly LEAPS puts, are long-dated options that can provide a form of term insurance for a gold stash. (Puts give their owners the right - but not the obligation - to sell the contract's underlying asset at a fixed price until its expiration date.)

Ordinary GLD options are short-lived. Accordingly, most traders are interested in the options expiring within the next calendar quarter: contracts that terminate in August, September or October, for example. LEAPS, however, go out nearly two years.

To better understand how LEAPS work, let's look at an example: the January 2011 puts. You could buy a put that entitles you to sell GLD shares at $70 through January 2011, no matter how low (or high) they actually trade in the open market. GLD at $40? No problem. You can sell your GLD shares at $70 through the exercise of your put. GLD at $30? Still not a problem. You're good at $70.