In a recent article that was posted on Seeking Alpha, I discussed how gold has, surprisingly, been the best performing financial asset since the Federal Reserve announced the start of its tapering in December 2013. There are a few reasons why this is the case. The first is that the Federal Reserve has not stopped flooding the market with enormous quantities of new money, it has merely reduced the rate at which it prints money. Prior to the start of the taper, the Federal Reserve was increasing the size of the American money supply by $85 billion per month or just over $1 trillion per year. The start of the taper reduced this to $75 billion per month or approximately $900 billion per year. This is still a tremendous amount of money! Thus, the major argument of gold bulls, that the constantly growing supply of fiat money would result in more money chasing a fixed quantity of assets (including gold) and thus push gold prices up, is still very much intact.
There are also some geopolitical factors at work that could work in gold’s favor. One story that has not been well covered in the American media is how the world’s largest energy exporter (Russia) and the world’s largest manufacturer and second largest economy (China) have been moving their economies away from the petrodollar standard that has defined world trade since World War II. The leaders of these countries and others, primarily in the emerging world, are unhappy with the way the United States has been “abusing” (their word) the dollar’s position as the reserve currency. To support this move, both countries have been amassing huge amounts of gold. According to an article on Bloomberg dated February 11, 2013, Russia has added 570 metric tons of gold to its central bank reserves over the past decade. Granted, this article ran before gold prices collapsed from their all-time highs last summer. That collapse did nothing to slow Russian gold purchases, however. Over the same time period, China’s central bank was the world’s second largest gold buyer but Russia amassed a quarter more than the manufacturing superpower, according to Bloomberg.
There is also evidence that the world’s gold supply may not be as large as believed. Since the days of the Cold War, Germany’s central bank has held much of its gold in foreign central banks out of fear that it would be stolen during a Soviet invasion. Obviously, that is no longer a threat and Germany’s central bank is now demanding that the Federal Reserve Bank of New York return the 1,500 tons of gold that the Bundesbank stored there for safekeeping. However, despite the Fed’s claim that it has 6,720 tons of gold stored at the New York Fed alone, it requires seven years to return Germany’s 1,500 tons. Why? After all, the Fed claims to have much larger holdings on site than what Germany is demanding. In fact, the Federal Reserve Bank of New York does not actually have this gold but has leased it out to others, some of whom then lent the same gold out to multiple people or institutions. This practice dramatically increased the amount of reported gold in the financial system, much of which does not actually exist. So, now that the Bundesbank and the central banks of several other nations are demanding the return of their physical gold, the Fed will need to get its physical gold back from the organizations that it lent it to. This will result in pressure on gold as physical gold leaves the American and Western European financial systems to satisfy these redemption requests.
Because of this, gold is now looking much more appealing than it has at any time since its huge decline last year. Fortunately, there are ways for investors to take advantage of these developments. The most obvious one is to buy gold. For example, one could buy shares of the most popular gold ETF, the SPDR Gold Shares (GLD). This would not have been a bad trade as the ETF has greatly outperformed the overall market, as represented by the S&P 500 Index, so far this year:
GLD data by YCharts
However, it may be preferable to purchase physical gold. This would be particularly true if you plan to hold the gold for a long time and want the peace of mind that comes with being able to actually touch the gold. Of course, even this is no guarantee as illustrated by the large quantity of gold-plated tungsten being passed off as physical gold. If taking this route, be certain to get the real thing.
There is also another way to play gold, although it is potentially higher risk than the above options. On the other hand, this is a play that is much cheaper to execute and could result in higher returns than the above investments. That play is to use options to leverage yourself to gold prices.
The simplest way to execute this trade is to purchase call options against some financial instrument that is positively correlated to gold. For example, the SPDR Gold Shares ETF would be one such instrument. At the time of writing, units of this ETF traded hands at a price of $127.44. However, an investor could purchase a call option, even an in the money one, for significantly less. An in-the-money call option is a call option that has a strike price that is lower than the current stock price. For example, the June 2014 $60 call option currently has a bid price of $67.25 and an ask price of $67.75. This means that an investor could conceivably control one hundred ETF units for $6,775. It would cost $12,744 to purchase the same exposure by buying the ETF units directly.
There are other ETFs besides gold ETFs that also grant exposure to gold prices. One of these is the Market Vectors Junior Gold Miners ETF (GDXJ). This ETF tracks the Market Vectors Global Junior Gold Miners Index which consists of small cap companies that generate at least 50% of their revenues from gold or silver mining or have the potential to do so. As this ETF consists of shares of some of the smallest gold mining companies, many of which are highly levered, it is a rather risky play. This ETF is likely riskier than directly investing in the precious metal itself although it should be safer than buying the shares of any given junior miner. This ETF tends to be positively correlated to the price of gold because the stock prices of gold mining companies tend to be positively correlated to the price of the metal. However, since all of these companies derive the majority of their revenues from gold or silver mining and most of them are highly levered ventures, the share prices of these companies tend to rise faster than gold prices when the market is appreciating. The reverse is also true. Shares of these companies tend to decline more than gold prices when the price of the metal falls.
GLD data by YCharts
GLD data by YCharts
Thus, this ETF is essentially a higher risk, higher return way to play gold. Since call options tend to raise both the risk and the potential return of an investment, using call options to invest in this ETF is essentially a very high risk way to play gold prices but it also can deliver the highest return out of any play discussed here.
Buying a call option represents a bullish bet on the price of the underlying asset. Thus, when the price of the asset represented by the call option increases, the value of the call option will also increase. However, a call option is also a leveraged play so the value of the option will, in percentage terms, increase by more than the underlying asset. Therefore, the call option allows for a much greater return.
The risk of a call option comes both from the nature of it and from the fact that it is a levered investment. In the previous paragraph, I explained that a call option’s leverage allows for greater returns by offering a greater gain in percentage terms than shares of the stock or ETF that represent the underlying asset. The reverse is also true. Should the price of the underlying asset go down then the value of the call option will go down by a greater amount when measured in percentage terms. Call options are also only valid for a specified period of time and then they expire. Thus, if the underlying asset trades for less than the strike price of the option at the time that the option expires then the option is completely worthless and the owner of the call option will suffer a 100% loss of their investment.
In conclusion, purchasing call options against the Market Vectors Junior Gold Miners ETF may offer an opportunity for investors who believe that gold will continue its upward momentum to earn very high returns on their convictions. Before making such an investment however, it is important to understand the risks involved including the very real possibility of losing the entire investment. For this reason, purchasing call options to bet on an upward movement in gold should only be done with money that the investor can afford to lose.
Disclosure: I have no positions in any stocks mentioned in this article at the time of writing and no plans to initiate any such positions within the next 72 hours.