Silver and gold in 2011

Over the last year, both silver and gold have risen dramatically. Both of them, but especially gold, have been surrounded by hype of all sorts. So the question remains: As we enter a new year, is it time to invest further in gold and silver or to get out altogether?

The answer to this question lies in the purpose of the gold/silver investment. Such investments can serve many purposes. For those worried that there will be inflation in 2011, precious metals are a good place to be. As the value of the dollar declines, the value of these commodities are likely to rise. For those worried that there will be major disruptions in the world currency markets, again gold and silver are good places to be. These are investments that do well in times of panic; investors park their wealth here to avoid the turmoil in the other markets. For those who see China or the oil producing states as abandoning the dollar as a reserve currency, once again these commodities provide a haven in troubled times. Even for those who see only that China is increasing the size of its gold reserves and that certain other countries are following suit, gold, in particular, is a good place to be. The new demand for gold will drive the price ever higher. So, to summarize, for those worried about all sorts of geopolitical and economic events, gold and silver are good places to be.
But what can go wrong? Well, if the world economy gets stronger and stocks and bonds do well, money that is now parked in gold may exit quickly. If that happens, the price of the metals may drop rapidly. To me, this is the key. Gold can go down, but if it does, almost certainly the other sectors in which one is invested will do quite well. So I view gold and silver as hedges against the geopolitical and inflationary risks of the world economy.
In short, I believe that responsible portfolio management requires an investment in gold and silver of at least 5% of the total value of the portfolio to hedge against these risks. So how is the best way to do this?
First, there is the question of whether to invest in gold or silver. Historically, the ration between gold and silver prices has been about 16 to 1. At the moment it is almost three times that amount. If things go back to normal, the price of silver will rise dramatically. Even so, however, I believe that gold is the place to be for the bulk of the investment. It is gold that is being bought by the Chinese, Indians and other countries. Gold is not an industrial commodity the way silver has become. Gold is the best hedge.
Next, the question is should one buy bullion, gold funds, or stock in the gold mining companies. Bullion has the problem of storage and the fact that it produces no income. It is dead money, but it is an asset that you can keep out of banks, brokerage accounts and the like. If there is a total disaster, you can still have access to your gold. In truth, however, while this is appealing, it is not realistic for most people. Having gold around the house makes no sense. It is more like building a bomb shelter than making an investment . I favor buying gold etf’s for about 75% of the investment and stock in the miners for about 25%. Stock in gold ETF’s like GLD also generate no income. These ETF’s, however, have no company specific risks.
So how best to structure an investment in GLD? The key here is to leverage the amount of gold controlled and to use options to generate returns. One should buy far in the money long term options and sell short term out of the money calls against these long positions. For example, if one buys GLD September 100 calls, the cost at the close today was about $38.20 with the price of GLD at 137.03. This means that the long call has $37.03 of intrinsic value and $1.17 of time value. It also means that for an investment of $38,200 one can control $137,030 worth of gold and get both the full upside and downside for that large position. If one also sells the February 142 calls against the long position, one can get $2.01 per contract. This means that one is controlling the gold but paying a net of only $36.19 for a position with an intrinsic value of $37.03. The time value of the short position will decay much more quickly than that of the long position. By early February, the short position will get close to zero, and it can then get rolled out a month to something like the March 143 calls. My rule of thumb is that whenever one can roll out a month and up a dollar and get a credit of more than a dollar, it is a trade worth making. In essence, this provides an income on the investment of about $1 per month or $12 per year, for a return on the investment in the long calls of over 30%. If gold continues to rise, one also gets that increase up to the level at which one has sold the short position.
Obviously, one needs to watch the numbers on these investments very carefully. It may be necessary to close out the positions and re-establish them at different strike prices. Another rule of thumb that I follow is that I trade the long position for another one with a $5 higher strike price if I can clear at least $4.50 for that transaction. This lets me consistently reduce the downside risk as GLD goes up.
For those who want to invest in gold mining companies, my favorite at the moment is Yamana Gold (symbol AUY). If commodities rise over the next few years, Yamana’s results will soar as its new production comes on line. It has properties like Agua Rica in Argentina that have not yet even begun physical development but which hold enormous gold and copper reserves. I will post another time on the other details of Yamana. Suffice to say that in my opinion it will outperform the other gold stocks over the next few years.
Disclosure: I am long Yamana and have written both calls and puts on that company’s stock. I am long GLD long term calls and short GLD short term calls something like the illustration discussed above. I change these positions frequently, however. I also have similar positions in SLV, the silver equivalent of GLD. I also am invested in the stock of a few other gold and silver producers.
Final caution: gold and silver are not investments that ought be made and then ignored. Particularly if one is going to use a call strategy, one must monitor the position and adjust it as needed, sometimes as often as daily.