We have seen all too often where the financial markets collapse and rise in dramatic fashions. The problem for most investors over the past few years is that they did not know when to get out of the market, and conversely, did not know when to get back in. Market-timing is impossible, and any attempts to accomplish such feat usually ends up fruitless when compared to a holding strategy. Typically, market-players will look towards the latest hot stock, industry, or commodity. In 2007 we watched real estate peak; in 2008 we helplessly observed the rapid rise and fall of oil; in 2009, we saw our once beloved financials hit rock bottom, only to bounce back three-fold. So what is next for 2010? Gold.
The story with gold is all too familiar. The price steadily rises as the value of the US dollar drops. The price of gold has reached and exceeded all-time highs (but no quite yet in relative valuation terms when adjusted for inflation). Additionally, many articles are popping up all over the Internet talking about how gold will continue to surge, doubling and even tripling in value. As of market close on Thursday, December 3rd, 2009, gold stood at 1,204.9 per troy ounce. Over the past five years, gold has nearly tripled in value. Comparatively, the S&P 500 Stock Index is down about 8%. I have even read an article where a man bought $100,000 worth of gold bars, and buried them in the backyard.
Now for those of us that do not have liquid access to $100,000, there is an alternative to play the gold market: spider shares. A spider index is an exchange traded fund (ETF) that trades like a stock, but is tied to a collection of assets - in this case, gold. The index was created five years ago, and trades under the symbol GLD. The index matches the price of gold close to a 1:10 ratio (as of market close on Thursday, December 3rd, 2009, GLD stood at $118.70 per share).
The strategy here, however, is to not necessarily buy shares of the index, but to buy options on the index. Options are contracts that give investors the option to buy or sell a stock or ETF for a certain price (strike) at a later date. There is always a cost to get into the option contract, but the buyer is never obligated to exercise the option. Options are a great resource for hedging investing strategies while minimizing risk.
For example, if you feel that the price of the gold ETF will jump to $129 by January 15, 2010, then you can buy a "call" option for $1.05 per share (options are typically bought and sold in round lots of 100 shares), thus costing you only $105. Should the price not reach $129 by January 15, 2010, then you can let the option expire, and you have no further obligation. Thus, the maximum loss you can take on this position is $105. However, should the price rise to $150 by January 15, 2010, then you can exercise the option, and buy the ETF for $129, and then immediately sell if for $150, thus making $2,100 (not including the cost of the contract). Your maximum gain is unlimited, as the price could rise to any amount.
Conversely, if you are like me and think that the price will drop, you can buy a put option. Put options work just like call options, only in reverse. For example, if you feel that the price of the gold ETF will drop to $110 by January 15, 2010, then you can buy a put option for $1.13 per share, thus costing you only $113. Should the price not fall past $110 by January 15, 2010, then you can let the option expire, and you have no further obligation. Thus, the maximum loss you can take on this position is $113. However, should the price plummet to $100 by January 15, 2010, then you can exercise the option, thus making $1,800 (not including the cost of the contract). Your maximum profit is $11,000 (less the cost of the contract), as the price can only go as low as $0.00 (although highly unlikely).
In addition to buying options, investors can sell them as well. However, selling a call option on an asset you do not already own is the riskiest investment (called a naked call), as your maximum loss potential is unlimited.
Personally, I feel that the US Fed is feeling the pressure of the declining value of the US dollar, and will soon take measures to sure up the value. Thus, I am bearish on the price of gold.
Disclaimer: This article is not a solicitation for the purchase or sale of any asset or investment vehicle. Past performance cannot guarantee future results. All investments assume some level of risk, including complete loss of total money invested. Before investing, be sure to read the prospectus carefully and heavily consider all research associated with such investment. Opinion in article represents that solely of the author, and no other company or institution (or website). Author is not responsible for any actions taken as a result from reading this article.
My background: B.S. degree in Finance; passed series 7 and 63 in 2006; nearly 20 years of investment experience. I currently do not own any shares in GLD, but have purchased a 75 Jan 2011 put contract.