Long GLD/Short TIPS
The first of these pair trades is one based on convergence. Historically U.S. real interest rates have an inverse relationship with gold prices, a relationship that we have written about frequently. The basic premise is that when monetary policy becomes more accommodative, U.S. real interest rates decline and gold prices rise due to the ease in monetary policy. However, over recent weeks gold prices have fallen but U.S. real interest rates have remained low, and this pair trade is speculating that the two will converge again.
To execute the trade we would use the gold exchange trade fund GLD and the iShares Barclays TIPS Bond Fund, although futures can be used as well. GLD tracks the price of gold and TIPS tracks the price of Treasury Inflation Protected Securities. Since gold prices move inversely with real interest rates, it moves with the price of inflation-protected bonds, since yield and price move in opposite directions in the bond market. This relationship is demonstrated in the chart below.
However, if U.S. real interest rates declined from their current levels and gold prices fell (which translates to GLD down, TIPS up), then this trade would incur losses.
The trade would be executed as follows. One must match the legs of the trade dollar for dollar, not share for share. So for every share of GLD bought at $157.20, one must sell roughly 1.34 shares of TIPS to properly construct this trade. For example one could buy 100 GLD and short 134 TIPS.
Long DGP/Short GDX
This second trade is based on our view that gold mining stocks will continue to underperform the gold price itself. This is a view that we have held for some time and frequently have written about. We believe that owning gold mining or exploration stocks is a very poor way to gain exposure to the gold price and we have been actively discouraging using mining stocks as a gold investment vehicle since May 2008. For our reasoning for this view please read one of our articles on the topic.
We are bullish on gold going into 2012, and although we would not be buying mining stocks, that does not mean that gold stocks will not increase in value. They may well increase in value, but we think gold will still outperform the mining stocks. Therefore this pair trade is a long gold/short gold mining stocks position. This is something we have been suggesting throughout 2011 and we should point out that a long GLD/short GDX pair trade would have returned 26.2% during 2011.
However, we have decided to use DGP (PowerShares DB Gold Double Long ETN) in this particular trade as there is a chance that gold miners may match gold’s rise this year, but we put a very low probability of them performing twice as well as gold. We are suggesting using GDX (Market Vectors Gold Miners ETF), but the trade could also be constructed by shorting a basket of gold mining stocks of the traders choosing. This trade could also be executed using gold futures or GLD.
This trade will deliver losses if gold prices fall and gold mining stocks fall by less than half as much, or if gold prices rise but gold miners increase by more than double the rise in gold. We expect gold prices will rise and this rise will be larger than any rise in mining stocks.
The trade would be executed as follows. Again, one must match the legs of the trade dollar for dollar, not share for share. So for every share of DGP bought at $50.80, one must sell roughly 0.95 shares of GDX at $53.35 to properly construct this trade. For example one could buy 100 DGP and short 95 GDX.
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Sam Kirtley, SK Options Trading
Winners of the GoldDrivers Stock Picking Competition 2007
Disclaimer: gold-prices.biz or SK Options Trading makes no guarantee or warranty on the accuracy or completeness of the data provided. Nothing contained herein is intended or shall be deemed to be investment advice, implied or otherwise. This letter represents our views and replicates trades that we are making but nothing more than that. Always consult your registered adviser to assist you with your investments. We accept no liability for any loss arising from the use of the data contained on this letter. Options contain a high level or risk that may result in the loss of part or all invested capital and therefore are suitable for experienced and professional investors and traders only. Past performance is not a guide nor guarantee of future success.