Safehaven | Gold and Silver... How Do I Own Thee?... Let Me Count The Ways: Part II

April 05, 2009

Gold and Silver... How Do I Own Thee?... Let Me Count The Ways: Part II
by James Macfarlane

Mining ETFs and Mutual Funds

Category: Investment/Speculative
One simple way to diversify your ownership of the miners is through a vehicle that invests in a "basket" of Gold/Silver Mining Stocks. There are both mutual funds and ETFs that specialize in precious metals stocks. I will leave you to do your own research on the mutual funds, but the popular ETF for mining shares, GDX, requires a bit of explanation as to how it works (don't confuse GDX, an ETF composed of mining companies, with the GLD ETF discussed earlier, which simply reflects the price of gold bullion).

Many ETFs are based on an index of a class of equities rather than on the equities themselves. For example there is an ETF for the Dow Jones Industrial Average index (DJIA). If you want to "buy the Dow" - i.e. tie your fortunes to the rise and fall of this index - you can't just go out and buy the index. Before ETFs you would have to have purchased shares in every of the 30 companies listed in the average. That's why ETFs were invented. Owning a DJIA ETF is like owning an averaged amount of shares in each company. The ETF rises and falls in lock-step with the index.

When it came time to create an ETF for gold/silver mining companies, the question of which index to base the ETF on arose. One significant difference among the various precious metals indexes is the distinction between the inclusion of unhedged vs. hedged mining stocks. A hedged mining stock refers to a miner that hedges or pre-sells their precious metals well into the future. The miner enters into contracts with buyers that specify ahead of time how much the buyer will pay for the bullion once it is mined. Conversely, an unhedged miner does not enter into such long term contracts (over 1.5 years). Since unhedged miners have not locked in the price they will receive for bullion produced in the future, the share price of those companies appreciates far more during a gold/silver bull market.

The leading unhedged mining index is the Gold BUGS index (HUI). Gold BUGS is traded on the American Stock Exchange (AMEX, which is now part of NYSE). The BUGS part stands for Basket of Unhedged Gold Stocks. The leading hedged index is the Philadelphia Stock Exchange Gold and Silver Stock Index, XAU. Now I don't why, but there's no ETF for either of these indexes.

Fortunately though there is an ETF for an unhedged index that behaves quite similar to the popular HUI index. It is the NYSE Arca Gold Miners Index (GDM). I have seen convincing analysis from a trusted source (zealllc.com) demonstrating that the GDM closely tracks the performance of the HUI. The ETF for the GDM index is the Market Vectors Gold Miners ETF (GDX), also traded on the NYSE.

Phew. Let's go over that again. GDX is an ETF that tracks an index of 30 unhedged mining companies known as GDM, which in turn tends to track the performance of the widely followed HUI index. Investors looking for portfolio diversification in an easy to trade, highly liquid instrument, could consider this vehicle. GDX is traded on the NYSE. Just remember this is an index, not a mining company, and is subject to the liquidity of the ETF itself and the smooth functioning of the exchange.

Leveraged Investments - Options and Warrants

Moving another step up the risk/reward ladder we have options on gold and silver equities. If you are not familiar with options you must educate yourself before even thinking about using them, because they are remarkably risky. But let's at least do a brief overview to get everyone on the same general page. Options are a highly leveraged instrument that allows an investor to put up a relatively small amount of money to lock in ahead of time the price the purchaser will pay for various gold/silver equities such as ETFs, mining indexes, and mining shares.

Options are not used for safety, nor even for investment. They are a purely speculative tool that can multiply your investment in short order, or wipe out your entire entry fee even sooner. For perspective, we are now about as far away from physical gold that you can get. When you buy an option you are not buying the underlying equity it is associated with. Rather you are reserving the right to buy (or sell) the equity at some future date. If you think the price of the equity will go up you buy a call option. Conversely, if you think the price will go down you buy a put option. It works the same both ways. The option gives you the right to buy the equity at a prearranged price (the strike price), and no matter how high (or low) the price of the equity goes, you can still purchase the equity at the strike price. The difference between the strike price and the current price of the equity is profit (minus the cost of the option), because you can turn right around and sell the equity at the market price. But, you only have a certain amount of time before the option expires... and therein lies the rub. If the equity has not risen (or fallen) past the strike price (known as being in the money) before the expiration date arrives, or unless you have sold the option to someone else along the way, your entire investment is forfeit. Options are tempting because you pay far less for an option on an equity then for the equity itself. But time is your enemy with options trading. Perhaps the best way to scare you in to taking this caution seriously is to simply note that over 90% of all options expire without being exercised.

There are a wide variety of ways to play the options game, but it requires serious time and research to put the odds in your favor. Also, remember that options only apply to Paper Gold, not Physical Gold. Having said that, let's look at how options fit into the world of precious metals investing.

ETF Options

Category: Highly speculative
Earlier coverage was given to the gold and silver ETFs, instruments that allow you to trade in precious metals as you would a stock. Although an ETF is convenient, it provides no leverage. For example, the value of the popular gold ETF, SPDR Gold Shares (GLD), closely tracks the price of 1/10th oz of gold, with the ETFs price always matching the cost of that fractional amount of bullion. But as of 2008 you can also trade options on GLD, with one option controlling 100 shares of the ETF. GLD options are traded on the Chicago Board Options Exchange (CBOE).

Here is an example of the comparative profits that can be gleaned when an option trade works in your favor.

Purchase date: November 13th, 2008 ETF: GLD Share Price: $72.15. Cost of 100 shares: $7,215 Option price: $390 (1 option controls 100 shares). Cost of 18 options: $7,020 (Strike price $80, Expiration Date: 3/21/09)
Price of GLD		Profit from ETF	Profit from option
11/13/08 (purchase date)	$72.15	$0	$0
2/20/09 (market tops)	$97.80	$2,565	$25,110
3/20/09 (near expiration)	$93.59	$2,144	$17,280

If the market goes your way you can make good money

That trade worked out pretty good, leveraging profits by about 8:1. See the next example before calling your broker though.

Mining Index Options

Category: Highly speculative
Mining index options afford an interesting combination of diversity and leverage, providing the inherent risk diversification of a mining index ETF, with even greater leverage than that found in mining stocks alone. The main option play on the miners is vis-à-vis options on the GDX ETF (discussed above). Each option gives the buyer the right to buy (or sell) 100 shares of GDX at a specified price, with a variety of expiration dates available.

Here is an example of how an option trade can wipe out your capital.

Purchase date: July 23rd, 2008 ETF: GDX Share Price: $44.57. Cost of 100 shares: $4,457 Option price: $360 (1 option controls 100 shares). Cost of 12 options: $4,320 (Strike price $50, Expiration Date: 3/21/09)
Price of GDX		Profit from ETF	Profit from option
07/23/08 (purchase date)	$44.57	$0	$0
11/03/08 (near bottom)	$17.80	($2356)	($4,320)
3/20/09 (near expiration)	$37.55	($702)	($4,320)

Out of time and out of money

This is a more realistic eventuality for an options trade. The options player is permanently out $4300 and change. If shares had instead been purchased, the holder would simply be down, (perhaps temporarily) $700 and change. The option could have been sold prior to expiration, but it traded for only $15.00 on January 2nd and had no takers thereafter. As you can see, timing is everything! Yes, these have been real life examples.

Note: Although options are also available for the popular Gold BUGS index (HUI), trading volume is fairly light, whereas GDX options provide much better open interest and volume. The folks at zealllc.com have noted that since the GDM index closely follows the HUI index, the GDX options provide what is essentially a synthetic option for the HUI. GDX options are traded on the NYSE, and can be purchased through an equities broker.

Mining Warrants

Category: Investment/Speculation to Highly Speculative, depending on mine
Options are also available for individual mining stocks, but they are not called options. They are known as warrants. Warrants abide by rules similar to options; the right to buy the underlining equity at a specific price, and for a specific amount of time. Like options, warrants sell for a fraction of the price of the underlying stock. Thus you can control a given amount of shares in a mining stock with a fraction of the money you would lay out for the shares themselves. Warrants differ from options in at least three ways though; 1) the warrant is issued directly by the miner, 2) there is no equivalent of a Put² option with warrants, 3) warrants often have longer expiration dates, in some cases as long as 10 years. That last caveat can make a warrant very attractive if the mining company you are interested in has issued warrants (not all miners issue warrants). See links at end of article for a good reference on mining warrants.

Leveraged Investments - Double ETFs

Category: Highly speculative
ETFs have been mentioned several times now, as well as options on ETFs in the previous section. So what is a Double ETF? Quite simply, it is a 2:1 leveraged ETF. Before double ETFs existed the only way to leverage a traditional ETF was to purchase an option. With a double ETF, for every dollar the price of the underlying precious metal moves, the double ETF moves twice as far. Your profit (loss) is effectively doubled.

Be advised that double ETFs, like options, require precise timing. If the price of a double ETF moves against you, your loss is double a traditional ETF. That of course is clear. What is not so clear is that if the price then moves back to exactly where you purchased it, you are not at breakeven. In a traditional ETF you would be. This is due to the leverage, as each loss requires a bigger gain just to get back to break-even. The % of loss varies with how much the market moves. The losses are cumulative over time, ultimately resulting in less than 2:1 performance, even if the ETF has moved in your favor. Double ETFs therefore are best for shorter term trading. Here are some examples of popular gold/silver double ETFs:

Long
PowerShares DB Gold Double Long ETN (NYSE: DGP)
Proshares Ultra Gold ETF (Symbol NYSE:UGL)
Proshares Ultra Silver ETF (Symbol NYSE:AGQ)
Short
PowerShares DB Gold Double Short ETN (NYSE: DZZ) ETNs are riskier than ETFs. Do your research.
Proshares Ultrashort Gold ETF (Symbol NYSE:GLL)
Proshares Ultrashort Silver ETF (Symbol NYSE:ZSL)

Leveraged Investments - Commodity Futures

Category: Outright stupidity
Finally we come to the last well known way to "invest" in gold/silver, that being the commodity futures market. 99.9% of all people should avoid commodity futures as they are extremely risky. Unlike options, which although risky, have a cap on how much you can lose (the price of the option), a futures contract has no such limit. You can suffer extreme financial damage playing the commodities market. Futures trading is only being mentioned here to fulfill the goal of the article, which is to list all well known vehicles for owning/investing in precious metals. And, since references to futures trading pop up in the financial press frequently, so you may just want to know what the press is referring to.

A commodity futures contract is an agreement to have a commodity, such as wheat, or corn, or gold, delivered to you at some point in the future. Just as with options, the price of the commodity is agreed upon when the contract is made. Regardless of what happens to the open market price of the commodity between the time the contract is made and when it's fulfilled, it has no effect on the price of the contract. The idea of futures contracts originated in agriculture in order to give farmers the ability to determine how much they would receive for their crops prior to planting. This was, and is, a very beneficial system. The farmer sells a futures contract. The contract specifies the characteristics of the commodity (say Hard Winter Wheat), the amount of the commodity, and its price. A user of the commodity, say a grain elevator, buys the contract. The buyer puts up a small down payment, or margin, and pays the balance upon delivery. That is where the leverage comes in. The down payment locks up a controlling interest in the specified amount of the commodity. If the price of the commodity, say, doubles by the time the contract is due to be fulfilled, the seller must still sell the commodity at the agreed upon price. Both parties are obviously taking a risk, but for a farmer... or say a crude oil producer... the ability to lock in a sale price up front can make the difference in obtaining a loan to buy seed, or purchase oil recovery equipment, because they can tell the banker they already have a buyer for what they produce.

The original idea behind futures trading was that the buyer would actually take delivery of the commodity. Most futures contracts nowadays however result in the contract being liquidated before delivery takes place (this is especially true with gold/silver). In other words, futures trading is now much more a speculative play then it used to be, because so many of the participants are not producers. This is not a bad thing however. It is the speculators that provide the needed liquidity to keep the markets fluid. What is "bad" is that for the small investor, there is little protection against the market moving against you. If the price of a commodity you have purchased a futures contract for moves in the opposite direction you may be required to put up more money to maintain the margin on the contract. Naturally the contract can theoretically be sold before this happens, but there are times in extreme market conditions when no party may be interested in buying back your contract. You are responsible for the contract no matter how much the price moves against you, and with such a highly leveraged instrument (say 20:1), you can literally be wiped out. So again, don't play here.

Leveraged Investments - Options on Futures Contracts

Category: Highly speculative
We will climb down one notch on the risk ladder to mention that about the only way to "safely" play the commodities market is through options trading. You can actually purchase an option on a futures contract. You are, in effect, buying the right to at a later time buy the contract if the price of the commodity has moved in your favor. In that case the extreme risk associated with a futures contract is minimized to the price of the option.

But think of where we are at this point. We are about as far away as you can get from the original idea of buying gold and silver for safety. Remember, time is always your enemy when playing in the options sandbox. Uncertainty and market volatility make this an especially tough game these days. With Physical Gold, and certain forms of Paper Gold, time is on your side.

Summing It Up

There you have it. Around the globe millions of investors are making their play in gold/silver through one or more of these investment vehicles. Did this article cover every conceivable way to tie your fortunes to the price of gold and silver? Probably not. Gold jewelry was not really mentioned, although it is an item you would not really purchase as a pure investment play, since the melt-down value would be much less than the current price of bullion. Is it guaranteed that an investment in precious metals will pay off in the long run? There are no guarantees when it comes to the future. Still, under these conditions gold is an insurance policy that you almost can't help but to take out.

When making your decision regarding how to allocate your precious metals portfolio, always remember the difference between Physical Gold and Paper Gold. Physical gold and silver is bullion that you own outright and is in your hot little hand. Physical gold is an unleveraged, non-time sensitive holding. Behind Physical Gold comes the safest form of Paper Gold; an allocated account with auditing, such as the Digital Gold Banks. Any other form of gold is simply a bet on what will happen to the price of gold. If the currency were to fail, all the other forms of gold investing, except perhaps mining shares, could fail. Use your mad money if you choose to play with ETFs or any of the leveraged Paper Gold instruments.

How much of your portfolio should be allocated to gold? It's different for everyone. Certainly a good chunk, but not necessarily all of it. No investment is 100% safe or 100% certain. With physical gold there is always the chance someone could steal it. A bigger risk is that at some point the government will want your gold because it needs it to back a new currency (there may not be as much gold in Fort Knox as we have been led to believe because the government won't allow the holdings to be audited). On the other hand, the ultimate risk of using digital gold banks is that the government hosting the storage vault may nationalize the vault based on a "national crisis", i.e. that particular government needs to back a new currency as well. Still, for now gold/silver is a highly effective way of preserving wealth. It's also smart to keep a stash of cash outside the banks during this time. If one or more of the last five or so remaining large banks were to fail (these are the banks that are in the worst financial shape), a bank holiday might be declared, and ATMs could be non-functional for a period of time.

Be patient. Accumulate gold and silver coins. Given the uncertainty of the future, although it is highly likely an extreme crisis is coming in all paper currencies, it is uncertain as to when it will hit. There is an enormous effort underway to hold the value of paper currencies. The effort will ultimately prove futile however, as the world will come to care more about return of principal rather than return on principal, and thus flee paper money.

Be safe. Stay awake. Keep smiling. You're prepared. The world is changing, and the coming changes are much deeper and broader based than simple economics. The future looks bright to this investor, but we're in for a quite a ride in the meantime. To quote a famous person, in the final analysis it's a good thing.

The End

Feedback to HowToBuyGoldSilver@hottrainingmaterials.com

Links:

Author's previous article entitled The Thin Red, White, and Blue Line

author's favorite sites for information, analysis, purchases
CMI Gold & Silver (purchases)
Blanchard & Company (purchases)
Zeal Speculation and Investment (analysis)
Gold-Eagle.com (analysis)
www.safehaven.com (analysis)
www.321gold.com (analysis)
www.prudentbear.com (analysis)
www.growthstockweekly.com (analysis of miners)
www.treasurechests.info (advanced analysis)
www.preciousmetalswarrants.com (Great site for mining warrants)

other hot links
Silver vs. gold
Great article on gold mining indexes
Argument that gold will not be confiscated
ETFs defined
Article on the GDX ETF
Dangers of double ETFs
Options on GLD
Wiki article on the 1933 Executive Order making gold illegal
Wiki article on Digital Gold Money
Article on 'street name' vs. direct ownership of stocks
Information on gold and silver mutual funds
Perth mint
Caution about Perth Mint certificates
Caution about gold confiscation in Australia
In support of Perth certificates
Article on allocated vs. unallocated gold storage
Good article on storing gold
Cost to insure Govt. debt

² For completeness it should be noted that it is possible to "short sell" a mining stock (a way to bet that the share price will fall) in the same traditional way you would short any other stock. This article will not cover this particular permeation though.

Back to Gold and Silver... How Do I Own Thee?... Let Me Count The Ways: Part I

James Macfarlane

James Macfarlane is a technical writer and part-time investor living in Santa Barbara, California. Having already drank the "here's what's really going on with the economy" kool-aid, he wrote this article in hopes of enlightening those dear to him who haven't.