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How To Short Gold "Safely"

September 30, 2010 | About:
When the cost of a commodity is well below its asking price, something is amiss. Such is the case with gold, as major producers are able to dig it out of the ground for around $500, and sell it for $1300 (and rising). This has encouraged majors like Barrick, Newmont, and Goldcorp to increase production and increase exploration. As a result, they have about 15-20 years (and rising) worth of proven reserves left at current production rates. As the price of gold continues to rise, that process will accelerate, increasing supplies.

On the demand side, sentiment is raging bullish, as discussed here. (For an additional example, consider the wildly positive comments towards gold on any Seeking Alpha article on the subject.) As contrarian investors know, when the investment world is bullish on a security, the price is soon headed in the opposite direction.

But for the long-term investor, it's impossible to know when that will happen. Perhaps some owners of gold will decide to sell at the same moment, causing a panic. Perhaps economic data will turn positive, and increase the likelihood of rate hikes, sending investors out of securities that earn no interest. Whatever the case may be, however, it could take years to happen.

Yet, those who wish to short gold often do so with puts. But puts expire, and since the long-term investor does not know when gold is going to head back to normal space, this is a dangerous game to play - even with LEAPS puts. Of course, one could buy a series of LEAPS puts, staggered several years out, but such a position can become expensive for the retail investor.

Going short physical gold or a gold fund is also a common option. But should gold's run continue or even accelerate, the investor is subject to margin calls and to principal loss. This may be perfectly fine for a trader looking to time the gold decrease, but is not suitable for the long-term investor who wishes to avoid the risk of losing his entire principal before the price drop occurs.

The best option for such an investor may be the purchase of an ETF that is short gold (using puts, derivatives etc). There are three commonly used ETF/ETNs of this nature, including DGZ, DZZ and GLL. The benefit here is that even if gold rises to astronomical heights and takes many years before it comes back down to a reasonable level, it is not likely that the investor will have lost his entire investment. The reason for this is that as gold rises, the positions of these ETFs are adjusted so that each percentage move in gold results in a similar percentage move (in the opposite direction) in the ETF. DGZ and DZZ are adjusted monthly, while GLL is adjusted daily. The retail investor would experience much in the way of transaction costs were he to construct a short position and attempt to re-adjust its size daily.

One thing to watch out for, however, is that DGZ and GLL attempt to double the percentage change in gold (in the opposite direction). For example, if gold rises 5%, DGZ is likely to fall 10%. As such, a 50% move in gold in a single month (for DGZ) or a single day (for GLL) will wipe out the investor's entire position. This is unlikely, especially for GLL which is adjusted daily, but not impossible, particularly if bubble frenzy catches fire at some point. There are also other risks involved with these ETFs, so investors should be sure to have read and understood the fund prospectus before making a decision.

Once the decision is made to choose one of these short ETFs, it also becomes a difficult task to determine when to sell. While value investors may agree the current price of gold is higher than it should be (due to the wide difference between production costs and price), it's difficult to know exactly what the price should be. This inability to determine a sell point is another challenge when it comes to shorting gold, though one that is not all that unfamiliar to value investors. (e.g. Sometimes one can tell that a stock is undervalued, even though one can't put a number on its exact worth.)

Bubbles can take years to pop. As such, many who are not gold bulls choose to sit on the sidelines rather than risk their capital going short. For those who are willing to wait years (if necessary) and who understand the fact that the price of gold could rise substantially in the interim, going long a short ETF may be a better option.

Disclosure: None


Saj Karsan

About the author:

Saj Karsan
Ravi Nagarajan is a private investor and Editor of The Rational Walk website. Ravi focuses on applying value investing techniques to find securities trading well below intrinsic business value. Ravi has over 15 years of experience in the financial markets and started investing on a full time basis in 2009. From 1996 to 2009, Ravi held a number of technical and executive level positions in the commercial software industry. Ravi graduated Summa Cum Laude from Santa Clara University with a degree in finance. Visit his website The Rational Walk

Visit Saj Karsan's Website


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Comments

Josh Zachariah
Josh Zachariah - 4 years ago
"The market can stay irrational longer than you can stay solvent" - John Maynard Keynes

I think it can be equally risky shorting gold as it would be hopping onto the bubble, but I agree with you that it is a bit pricey.

Josh Zachariah
kfh227
Kfh227 premium member - 3 years ago
This aticle was talking about shorting gold a year ago. Now that it is 2-4x the cost to actually dig the stuff out of the ground I am thinking about shorting.

Might dabble in a short position if it hits $2500. This Friday could be a big day. Hints of no QE3 coming should occur along with other stuff. Slow recovery will be reiterated.
superguru
Superguru - 3 years ago
Just because something is not as cheap as it was few months/years back does not mean it is in bubble. Till dollar keeps devaluing Gold will keep going up. Any recovery seems at least 2 years away so gold still has enough time to run.

I just heard some one from Royce in an Consuelo Mack interview saying Gold dollar adjusted price should be around $2300.00 and it is not in any bubble.
kfh227
Kfh227 premium member - 3 years ago


Depends on what "dollar adjusted" means. If this is just inflationary adjustments, that would mean that Royce is using the 1980 gold peak as his gold cost basis and tacking on an extra 10-20%.

Today going forward, I'd rather go buy USG for $7/sahre than gold.

Housing market is going to recover soon. "Housing market" being defined as new homes actually being built, not the prices of old homes. Demand for raw materials used in housing is due to jump.
DaveinHackensack
DaveinHackensack - 3 years ago
I bought a lottery ticket to bet against gold today: the $147 strike March GLD puts today @ $3.25.
Josh Zachariah
Josh Zachariah - 3 years ago
"Today going forward, I'd rather go buy USG for $7/sahre than gold."

Couldn't agree more. I'd mortgage my first born's college savings on USG stock

Josh Zachariah
DocMoney
DocMoney - 3 years ago
I know a way to safely short gold (or anything in an upstroke stage of a bubble):

Don't.
DaveinHackensack
DaveinHackensack - 3 years ago
USG has gone bankrupt before. You're not worried it might go bankrupt again?
DaveinHackensack
DaveinHackensack - 3 years ago
Those GLD puts I bought yesterday are up 27% so far today. And this post I wrote a few weeks ago, "Why you should consider hedging if you own Gold" is starting to look timely.
Josh Zachariah
Josh Zachariah - 3 years ago
I'm very worried USG will go bankrupt again. But the reason for their 2 bankruptcies are unique. One related to excess leverage (their interest expenses now are reasonable) and the 2nd to asbestos claims, which are completely eliminated. The company has $900 million in cash and credit lines which should provide for another 3-4 years of heavy losses. In the rare event of a housing bust that lasts longer than that time then yes a chapter 33 may be in order
kfh227
Kfh227 premium member - 3 years ago


USG has gone bankrupt before. You're not worried it might go bankrupt again?

Giving their FCF generating ability relative to debt I am not worried. Once housing starts pick up again, USG is going to benefit.

Are you referring to the asbestos related issues from 5 years ago or from the early 1990s? There is no possibility of USG getting sued over asbestos going forward.

Worse case is the Buffett pays a fair price for USG. And I think that if he got it for $18, it would be a steal to him. I honestly think USG could easily be at $40 in 5 years time. problem is,I don't know that. I do know that for $8/share USG is very much undervalued. Instead of DCAing, I did some Jan 2013 calls at the $5 strike. Because of the options, USG is probably my largest single holding where holding is defined as number of shares controlled. Playing second fiddle to WFC :-)

I'll go that path. 50% USG + 50% WFC is going to way outperform Gold over the next several years.
kfh227
Kfh227 premium member - 3 years ago
Also, if Buffett converts his convertable debt, there is a lot of debt that is wiped off the balance sheet.

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