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Barel Karsan
Barel Karsan

Shorting Gold "Safely"

September 30, 2011 | 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 $1600. 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 (the last week or so aside), as discussed here. 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 this recent slide will be a turning point. But perhaps it won't. At some point sooner or later, 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 DZZ 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.

About the author:

Barel Karsan
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now pre-order his book Invest Like a Guru on Amazon.

Rating: 2.4/5 (17 votes)


Jo-Jo - 5 years ago    Report SPAM
I agree with the author that inverse ETFs are a nice safe way to short something, although shorting a commodity certainly isn't isn't very inline with value investing. I think anyone reading this should be careful, however, as the author seems to be saying that an investor might consider holding inverse and leveraged ETFs for years, which probably isn't a very good idea. Inverse ETFs use futures contracts, and sometimes other harder to define methods to set their value, and the leveraged ETFs use leverage, obviously. These things will erode the value of the ETF with time (not to mention increase the expense of the the ETF). Also, the further the price of the underling asset (in this case gold) moves, the less impact the movement will have on the value of the leveraged, or inverse, ETF, so you will likely not lose all of your money if the price of gold goes up %50, and you will not double your money if the price of gold goes down %50.

These ETFs are designed for short term traders who will hold them for maybe a month, or even a day, but not much longer than the term over which their value is calculated. For long term investing you should only buy regular ETFs.
Skal401 premium member - 5 years ago

Stay away from ETF's that attempt to double or triple short.

Also, trying to time a "short Gold" trade is extremely difficult.

Quite simply, if you think Gold will continue its decade rally, using a small percentage of your Risk Asset money may be a good form of diversification. Gold and Silver should be looked at as Risk Assets due to their high volatility history.

If you think Gold has run its course and the big correction has just begun, then don't hold any. The "short gold" trade is a tough one that I personally would avoid.

Just one investors opinion !
David Pinsen
David Pinsen - 5 years ago    Report SPAM
I shorted gold safely and successfully recently. Then I flipped around and bought a few calls on GLD. No such luck with those yet.

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