Hedging Gold

By Brad Zigler

I suppose I shouldn't have been surprised by the number of visitors to the San Francisco Hard Assets Conference who wanted to talk about wrestling the risk of their gold stock investments. After all, 2008 has turned out brutal for gold miners. Witness the AMEX Gold Miners Index off by 46% for the year.

Some of the conferees have been puzzling over their hedging options. And there are plenty of them: options, futures and exchange-traded notes, to name a few. This array leaves many wondering which hedge is optimal.

If you're pondering that question yourself, you first have to ask yourself just what risk you want to hedge. In a so-called "perfect" hedge, price risk is completely checked, effectively locking in the present value of an asset until the hedge is lifted.

Is that what you really want, though?

A less-than-perfect hedge neutralizes only a portion of the risk subsumed within an investment. Gold stocks, for example, provide exposure to both the gold and equity markets. Hedging a gold stock with an instrument that derives its value solely from gold may dampen the volatility impact of the metal market upon your portfolio, but leaves you with equity risk. This may be perfectly acceptable if you feel stocks in general - and your issues in particular - are likely to appreciate. Hedge out the gold exposure and you're more likely to see the value that the company's management adds. If any.

We touched on this subject in recent Desktop columns (see "Gold Hedging: Up Close And Personal" and "More On Hedging Gold Stocks").

More than one Desktop reader asked why the articles proposed a hedge strategy employing inverse gold exchange-traded notes - namely, the PowerShares DB Gold Double Short ETN (NYSE Arca: DZZ) - instead of stock-based derivatives such as options on the Market Vectors Gold Miners ETF (NYSE Arca: GDX).

Well, we've mentioned one of the advantages of a gold-based hedge already, but the question deserves a more detailed answer. Let's suppose, for illustrative purposes, you hold 1,000 shares of a gold mining issue now trading at $50 and are concerned about future downside volatility. [Note: The prices shown in the illustrations below are derived from actual market values.]

AMEX Gold Miners Index And ETF

The AMEX Gold Miners Index is a modified market-capitalization-weighted benchmark comprised of 33 publicly traded gold and silver mining companies.

While price movements in the index are generally correlated with the fluctuations of its components and other mining issues, the relationship isn't perfect. Close, but not perfect. The Gold Miners Index represents the market risk, or beta, specific to gold equities. Any hedge that employs an index-based derivative will need to be beta-adjusted to compensate for any differences in the securities' volatilities.

You have to consider the proper index-based derivative to be used in the hedge. The GDX exchange-traded fund could be shorted, but that would require the use of margin, something that some investors might abhor.

If you're not put off by margin, you'll first need to size your hedge. And for that, you'll need a beta coefficient for your stock. A quick-and-dirty beta can be approximated by taking the quotient of the securities' volatilities or standard deviations (you can get a stock's standard deviation through Web sites such as Morningstar and SmartMoney, or you can derive a beta more formally through a spreadsheet program such as Excel).

Gold Stock Volatility ÷ ETF Volatility = 94.8% ÷ 81.8% = 1.16

The ratio tells you how to calculate the dollar size of your hedge. If your stock is trading at $50, your $50,000 position would require $58,000 worth of GDX shares sold short. If GDX is $23 a copy, that means you‘ll need to short 2,522 shares.

Once hedged, you'll still carry residual risk. The volatility correlation could shift over the life of the trade, leaving you over- or underhedged. So you'll need to monitor the position for possible adds or subtractions. Hedging is not a "get it and forget it" proposition.

You'll also need fresh capital to place and maintain the hedge. There's the initial cash requirement of $29,000 (50% of $58,000) and possibly more if you hold your hedge through significant rises in GDX's price.

GDX Options

You can avoid margin altogether by using certain GDX options instead of a short sale. Purchasing puts on GDX, for example, gives you open-ended hedge protection against declines in gold equities like a GDX short sale but with a clearly defined and limited risk. There's no margin required, but you'll have to pay a cash premium to buy the insurance protection. And, like an insurance contract, the coverage is time-limited.

Let's say you can purchase a one-month option that permits you to sell 100 GDX shares, at $22 a copy, for a premium of $245. Keep in mind that the put conveys a right, not an obligation. You're not required to sell GDX shares. At any time before expiration, you can instead sell your put to realize its current value, or you can allow the option to expire if it's not worth selling.

Just how does the put protect you? Let's imagine that, just before expiration, GDX shares have fallen to $10. Your put guarantees you the right to sell GDX shares at a price that's now $12 better than the current market. That's what your option should be worth: $12 a share, or $1,200. If you sell it now, you'd realize a $955 gain that can be used to offset any concomitant losses on your gold stock.

To figure out how many puts are necessary to fully hedge your stock position, you'll need to extend the ratio math used previously.

Option prices only move in lockstep with their underlying stocks when they're "in the money" like the put illustrated above. The expected change in an option premium is expressed in the delta coefficient. If the delta of the $22 put, when GDX is $23, is .40, the option premium is expected to appreciate by 40 cents for every $1 GDX loses.

The arithmetic used to construct the full hedge is:

[Stock Value ÷ (Delta x 100 Shares)] x Beta = [$50,000 ÷ (.40 x 100)] x 1.16 = 1,450 puts

Here's where the efficacy of the GDX options hedge really breaks down. GDX's high price volatility has inflated the cost of hedge protection to impractical levels. The hedge would cost $245 x 1,450, or $355,250; much more than the potential loss that would be incurred if you remained unprotected. Clearly, the cost of hedging gold equity market risk, like the cost of insurance after a catastrophe, has been puffed up to protect the insurer.

Of course, you can elect to hedge only a portion of your stock position, but the high premium necessitates a large "deductible" on your market risk.

Wrapping Up

You'll note that some gold mining issues have options themselves. Using these as hedges in the current market presents another set of problems.

Given that the volatilities for individual issues are higher than that of GDX, the stock contracts are even more expensive than index options. Using stock options, too, would hedge away management alpha. Individual options, as well, are inefficient if you hold multiple mining issues in portfolio.

Now, consider the contrasting benefits attached to using the DZZ double inverse gold notes in your hedge: 1) no overpriced insurance cover, 2) you get to keep your stock's equity and management risk; you're only hedging out gold's volatility, 3) a single purchase can hedge any number of mining issues in portfolio, and 4) your insurance doesn't expire.

Seems to me that DZZ has the edge.

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