How to Hedge Gold

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"We don't advise jumping off the gold bull's back, but consider taking out a little short-term 'insurance' on your precious metals profits."

Gold prices have had a phenomenal run over the past year, but the distinguishing feature of the market in recent weeks has been extreme volatility—volatility that has many investors nervous about protecting the big profits they've rolled up and looking for ways to hedge gold.

Now, we don't advise jumping off the gold bull's back just yet—especially since Money Morning's leading gurus see a gold price climb to $5,000 possible over the long haul. But you may want to consider taking out a little short-term "insurance" on your precious metals profits.

In fact, we suggested readers do just that in the Aug. 22 issue of Money Morning Private Briefing. We even went a step further and issued step-by-step instructions for a gold-hedging strategy.

Just two days later, on Aug. 24, gold suffered its third-worst down day in history, plunging 5.6%.

Readers who took our advice reaped windfall profits as a result. And now we're giving you the same opportunity.

We're back today with another strategy to help "insure" your gold profits.

The Secret Way to Hedge Gold

The only thing you need to do to hedge gold is follow this simple options strategy.

As with most option strategies designed to lock in existing profits, this one begins with the purchase of an at-the-money CME gold put option—one for each gold futures contract you own (or one for each 100 ounces of gold you hold in other forms).

[Editor's Note: For those unfamiliar with options, a put option gives its owner the right to sell a specific underlying asset at a designated price for a limited period of time. For example, an October Freeport-McMoRan Copper & Gold Inc. put option with a strike price of 42 would give its holder the right to sell100 shares of FCX common stock at a price of $42 a share at any time between the date of purchase and the option's stated expiration date, in this case, Oct. 21, 2011. A call option, the other basic type of option, would give its holder the right to buy a given asset at a specified price for a limited period of time.]

Normally, that would be sufficient to protect your gains, but this time there's a catch. The huge jump in volatility—i.e., the Chicago Board Option Exchange's (CBOE) Gold Volatility Index is trading near its all-time high—has resulted in sharply higher option premiums.

The price of an at-the-money gold put has nearly doubled over the past month—from roughly $56 an ounce ($5,600 for a full 100-ounce contract) to more than $100 an ounce. That means that, near the close on Monday, with December gold at $1,813.30, it would have cost you $10,190 to buy the at-the-money December $1,810 put option as insurance.

That's just too expensive, since it means the gold price would have to fall below $1,711.40 an ounce before your insurance would even kick in, costing you more than $10,000 in current profits.

Fortunately, the increased volatility has also driven up the prices of gold call options—and that means you can use one of them to offset much of the put's higher price.

In a nutshell, here's how the modified two-pronged "insurance policy" would be established, using the actual prices available near the close on Monday, with the December gold future at $1,813.30:
  • You buy an at-the-money December $1,810 gold put at a premium of $101.90, or $10,190 for the full 100-ounce option contract.
  • You simultaneously sell a deep out-of-the-money December $2,000 gold call at a premium of $43.40, or $4,340 for the full contract.
  • The net cost of the insurance policy thus becomesjust $58.50, or $5,850 for the combination (the $101.90 cost of the put you bought minus the $4,340 premium you received for selling the call).

With this option combination in place, the most you can lose is $6,150, regardless of how far the price of your gold holdings might fall between now and the options' expiration date—Nov. 22, 2011.

Even if gold plunged all the way back to $1,483.70, where it stood on July 1 of this year, you'd give back just $6,150 of your profits—which could be as much as $32,960 assuming you bought at the low (and much more if you bought a year ago).

Even better, if gold reverses again and moves higher, you continue to profit with this two-pronged hedge—gaining dollar for dollar with the gold future until the price goes above the $2,000 strike price of the call option you sold (reduced, of course, by the $5,850 premium you paid for your insurance).

The accompanying table shows the possible outcomes for this option hedge position at every gold price from $1,400 to $2,500, assuming it was initiated near Monday's close.

You'll have to adjust the option strike prices used in the strategy based on gold's price when you make your move, but the numbers should be similar at almost any level. Be aware, as well, that you can adjust the risk/reward characteristics of the hedge by choosing puts and calls with different strike prices.

For example, if you feel Monday's close was the bottom of the current pullback, you could buy an out-of-the-money put rather than the at-the-money put—say the December $1,790 rather than the December $1,810. The "insurance" provided by that put wouldn't kick in quite as soon, but it would be more than $1,000 cheaper up front.

Similarly, if you feel it's unlikely gold will rally substantially before the Nov. 22 expiration of the December options, you could sell a call with a lower strike price than $2,000—say the $1,900 call, which was priced at $68.30 near Monday's close. That would bring in a larger premium ($6,830) and reduce both the initial cost and the maximum risk of your hedge position. However, it also would cost you any further gains should gold rise above the $1,900 strike price of the call before expiration.

The options on Comex futures have substantial liquidity—an average daily trading volume near 4,000 contracts and an open interest in excess of 1 million contracts across all months—so they can be easily adapted to hedge both futures positions and physical gold holdings over almost any period of time throughout the coming year. And, if you're still nervous when the first set of options you use expires, you can reposition your hedge with options for more distant delivery months—such as the February or April 2012 contracts, with options expiring on Jan. 26 or March 27, 2012, respectively.

Options—generally traded on the Chicago Board Options Exchange (CBOE)—are also available on most of the leading large-cap and mid-cap gold mining stocks, as well as the leading exchange-traded funds (ETFs) that invest in physical gold and gold stocks.

The prices of the ETFs that invest in physical gold or gold futures fairly closely track the actual price of the yellow metal, so you can use the puts on them to either directly insure your fund shares or to insure smaller holdings in physical gold. Just buy puts on enough ETF shares to match the present value of your bullion.

The important thing to remember is that regardless of whether you're invested in bullion, gold coins, gold futures, gold funds or mining stocks, using options in a strategy like this will allow you to protect your gains without having to exit the market and miss the chance for even more profits.

If you're not comfortable with options, you can also hedge gold by taking short-term positions in so-called "inverse" ETFs. That includes the PowerShares DB Gold Short ETN. These funds rise when gold's price falls, providing gains that can offset losses when your long-term gold positions suffer temporary reversals.

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