Sometimes, things come back to haunt you. Things (or people) like Dennis Gartman. Gartman, an institutional advisor and newsletter writer, was once the most bullish proponent of gold among the non-slavering set. In April, however, after three years of scale-up metal buying, Gartman abandoned the metal ("A Gold Bull Stops Running"), complaining that gold's back had been "broken."
There has been, among gold bugs, more than a little pooh-poohing of Gartman's notion. Gartman's pronunciamento was made when COMEX gold traded at $912. Since then, prices have gyrated between $977 and $849.
Friday, as gold settled at $858, Gartman took to the airwaves on CNBC's "Fast Money" to intone darkly about gold's prospects once more. Gold's failure to make new highs and the long-building bottoming in the dollar, he says, will keep him out of gold for a long time to come.
So what of those folks who followed the pre-April advice of Gartman and others to buy gold mining stocks, but hung on, hoping that things would turn ‘round? How have they fared?
I had a chance to meet some of these folks at the New York Hard Assets Conference, a venue in which Gartman himself spoke ("Hard Assets Heresy"). At the conference, I gave a presentation on hedging mining stock holdings against gold's volatility ("Hedging Gold's Volatility").
The hedge examples given back then deserve an update.
What if, for example, we look at how the risk of remaining long in the Market Vectors Gold Miners ETF (AMEX: GDX) could have been managed in the GPP (Gartman Post-Pronunciamento) environment with a purchase of the Deutsche Bank Gold Double Short ETN (NYSE Arca: DZZ). The DZZ note is designed to deliver twice the inverse performance of the futures-tracking DB Gold Index.
From the February 28 launch of DZZ trading through the eve of Gartman's gold reversal (April 18), the ETN cranked out an annualized volatility of 54%; the gold mining ETF's standard deviation over the same time was 45%. As the ETN was more volatile than the ETF, an investor needs fewer ETN shares - in this case only 84% - for a full-dollar hedge.
GDX closed at $49.30 on April 18; DZZ finished the day at $27.24. A 100-share GDX position could thus be hedged by 152 shares (($4,930 ÷ $27.24) x .84) of DZZ.
GDX Vs. DZZ
By the time Gartman made his CNBC performance Friday, GDX shares has swooned 26% from their April 18 level. DZZ, meantime, had appreciated 14%, reducing the hedged shares' loss to only 8%.
Now, an 8% loss is certainly better than a 26% drubbing. But why not just sell the GDX shares? Why not, indeed. I asked that very question of many investors in New York and most wouldn't countenance the idea of abandoning their gold stocks.
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This article has 31 comments:
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User 232761
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4 Comments
Aug 11 04:43 PM-
Randy Fay
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Aug 11 05:00 PM-
wb100
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5 Comments
Aug 11 06:11 PM-
GKM
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Aug 11 06:39 PM-
CLH
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Aug 11 06:54 PM-
Jason T
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Aug 11 09:23 PMThose who don't know these answers will think gold has peaked. Those who have knowledge know otherwise.
Wall Street can be looked at as a place where smart people take money from dumb people.
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marc822
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3 Comments
Aug 11 10:48 PM-
Brian in Montreal
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44 Comments
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Aug 11 11:37 PMI would do things differently for gold. The shares seem to move faster, and the reasons to hold gold seem to be reasons not to hold the stocks.
So I have had success with DZZ, but more with HGD.to it's the double inverse of XGD.to (TSE gold stocks basket) there is an HMD.to (Mining in general) and HBD.to (bullion down) but until recently the volume was terribly light. (also for fun HOD.to oil down HED.to oil stocks down)
Then when the gold dust clears, take your profits and you still will have your gold.
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Brian in Montreal
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Aug 11 11:41 PM-
JBP
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47 Comments
Aug 12 12:03 AM-
User 58987
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3 Comments
Aug 12 01:01 AM-
silveraxis
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Aug 12 09:34 AM-
User 30121
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343 Comments
Aug 12 09:36 AM-
Managing Editor
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Aug 12 09:57 AMPut options are indeed an possibility, though they come with a whole new set of considerations. DZZ offers twice the inverse return of its underlying index without an extrinsic cost. That's a degree of leverage that exceeds that of an at-the-money option.
An option is a wasting asset; if it's out of the money at expiration, the put premium is forfeit. Holding a GDX put with GDX shares, in effect, creates a long call on GDX. And, as we all know, calls can sometimes expire worthless.
There's no such cost in DZZ. Neither is there an expiration, so rolling costs are eliminated.
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Beabaggage
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72 Comments
Aug 12 10:18 AMRun fraidy cats run, this is the time to average into mining stocks selling well below book with high cash flows & no debt !
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FoxV
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26 Comments
Aug 12 10:21 AMRight now we're in the Olympic glow, but that means just two more weeks left of the Chinese getting pushed around by Hank and Ben. When the torch goes out, the cloves come off.
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Barbacana
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3 Comments
Aug 12 10:44 AMJason T has a slightly longer time horizon. The current bunch of politicians (both parties) will destroy the value of the dollar. Their solution to all problems will be ensure that more money is printed. Bernanke will go along with that if he wants to keep his job.
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bowman711
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136 Comments
Aug 12 01:12 PMThe Great Depression is usually blamed on the Fed raising interest rates. I think they don't want the blame this time, so they are passing on the credit constriction to the banks or other financial institutions. Gold bugs need to not only look at whether the Fed raised or lowers interest rates, but to what the financial institutions are doing with what the Fed gives them.
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Kelly Lieberman
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241 Comments
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Aug 12 01:17 PMThere comes a time when you take a look at the overwhelming evidence around you and there is the truth.
I have a friend when faced with the lipstick, lies and credit card charges still could not believe her husband's affair...not until the child and the paternity suit.....
It is time to face the facts that there is little hocus pocus left and the mess we are facing is around the corner.
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arwerth
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18 Comments
Aug 12 03:57 PM-
Francis Schutte
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Aug 12 05:41 PM-
User 125692
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2 Comments
Aug 12 11:42 PM-
NOWHEREMAN
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1499 Comments
Aug 13 04:21 AMAnother shoe has been dropped on the consumer. One third, that is 1/3rd of US home prices have dropped below their respective outstanding mortgages. Lets raise interest rates to fight deflation!
The US dollar's brief rise during a war induced shortcovering rally will evaporate when the rest of the world figures out that they are in better shape than we are. Meanwhile, the Qtrly earnings of the US Internationals will take a big hit on currency translation if the Dollar stays at elevated levels. Be Careful what you wish for.
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Managing Editor
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Aug 13 09:35 AM1) The hedge ratio needs to be adjusted dynamically, and/or
2) There's something "wrong" with the management of the companies making up the underlying index.
If the hedge ratio remains constant over the life of the hedge, gold's influence from GDX should be negated, allowing the underlying companies' management "alpha" to emerge
There was an 8 percent residual loss after hedging. A little number-crunching should tell you if it's the fault of the hedge or of company management.
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ktchnsnk
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2 Comments
Aug 13 11:36 AMseconds?
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silveraxis
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Aug 13 09:00 PMA call option is not the same as a long position combined with a put option. For one, the call option will generate capital gains if you sell for a gain or it expires in the money. Meanwhile, the long position hedged with a put remains tax free as long as you hold it. There are other very fundamental reasons why you cannot equate the two.
Even then, a call option is still better than your long GDX short DZZ strategy. As I already stated, the option will let you keep the entire upside while DZZ neuters it. The cost of capital is also much lower with the put; you fail to consider the time value of money tied up in GDX and DZZ. Worse, one really can't know how good a hedge DZZ is going to be up front, as you reminded us. This causes you to allocate too much to the short leg or else suffer losses related to poor correlation.
With an at-the-money option, you know precisely your loss up front--it is the option premium. In fact, buying a put to hedge a long position should be viewed as a tradeoff -- taking a known loss in exchange for an unknown one. You might know this by another term: insurance.
As for your suggestion we should do some math to figure out why the long GDX short DZZ are not perfectly correlated, that would be a waste of time. Everybody knows gold and gold stocks don't move in perfect unison. It has nothing to do with company management. But even if they were perfectly correlated, you couldn't exactly offset a loss since the correlation is not a flat line along every price point. The easiest way to see this is to realize that the long leg can go to infinity but the short leg can only go to zero. That means if you think GDX is going up 1000% in the next few months but might also go down 50%, then DZZ might be an okay tool (still not as good as a put option) since it could only go to zero which still gives you 900% overall gains. The reason is simple: an option gives you more leverage along the entire price curve. This works in inverse as well but to a much lesser extent. Thus the math is a bit more complicated than you imply: it is not linear math but rather logarithmic math (looking for my high school math textbook as I write this)
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Managing Editor
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Aug 13 11:32 PMThere are more unknowns embedded in options than in stocks. Each of these "greeks" (delta, gamma, kappa [vega] and rho) is a variable risk factor that influences the option's price trajectory. The only "insurance" one has is in the expiration pay-off. One pays for it through the premium. Option premium must be paid to roll the insurance forward. No premium is attached to the purchase of stock.
Don't get me wrong. I'm a big believer in options. But not everyone else is.
The hedge example presented at the Hard Asset Conference was directed at shareholders who bought gold mining shares in the belief that their stock would outperform bullion. Hedging out gold's influence with DZZ does NOT negate the upside, it merely isolates the outperformance in the stock (if any) that isn't attributable to gold's movement. You'll see this illustrated in the examples presented in the "Hedging Gold's Volatility" article. The proposed hedge, in fact, relies upon this "mismatch" to allow the stock's alpha to filter through.
There were no GLD options extant at conference time and GDX options would hedge away the very alpha stockholders wanted to preserve.
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silveraxis
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Aug 14 02:05 AMNo, we don't need to examine the unknowns when buying an at-the-money put against a long position. We know everything we need to know: the premium and the term. We can divide the premum into the price of the underlying and annualize the term, and voila we have the annual cost of the put insurance expressed as a percentage of our position. That pretty much boils everything down to volatility.
Aha, now I get what you were trying to achieve! The fabled, non-existent (positive) alpha in gold stocks as a group! Too bad nobody has seen that in years, and even when it did exist, it always seems to "outperform" on the way down. In other words, gold stock volatility is skewed. Have you checked that for both GDX and DZZ?
If the goal is to seek alpha in gold stocks, you probably want to put together your own porfolio and not use GDX. Ideally, you would pick stocks that have a skew profile that is inverse to DZZ and obviously have good fundamental prospects.
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Managing Editor
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Aug 14 09:31 AMWithout considering delta, at least, how can you determine a hedge ratio? You won't get dollar-for-dollar price tracking between the option and the stock until the option's deep in the money.
GDX was used in the article above as a proxy, not as a trade recomenedation. Look at the examples given in the "Hedging Gold's Volatility" article and you'll see how the DZZ hedge worked against individual mining stocks and a small non-GDX portfolio. Alpha could, indeed, be stripped out.
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silveraxis
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Aug 21 12:07 AMI understand this wasn't the point of your article and I did read Hedging Gold's Volatility. I also understand how one could try to strip out alpha using such a method. But there are problems with the method as presented. I'll pick just three. First, you chose a "convenient" timeframe where DZZ was generating returns, not dragging on them. This made the return and risk-to-reward of the hedged portfolio artificially high compared to real world results. Second, I don't see where you took into account the fact that it took about $20,000 to acquire the hedge. In other words, $20,000 Hecla with a $20,000 DZZ hedge should be compared to $40,000 Hecla. I presume this would make the hedged returns when gold is climbing (which is most of the time in a bull market) even more pathetic. Third, you've created alpha but that doesn't mean it will always be positive. That's because you don't have ANY beta in the hedged portfolio at all. So, when beta is large and positive, you are going to have a large and negative alpha. And that would buy you exactly one calendar quarter as head of a hedge fund.
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Managing Editor
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Oct 05 02:39 PMTime premium is predicated upon volatility assumptions. All of the other inputs in an option price model could be similarly perceived by all market participants; the one variable that's unique to each trader is the forecast for the asset's volatility over the option's life.
There were no other time frames to consider for DZZ's performance when the hedge presentation was made. What you saw in the example was performance from inception. An update on DZZ's post-conference performance can be found on the Hard Assets Investors site at "Did You Hedge Your Gold Stocks? (www.hardassetsinvestor...) .
The purpose of a hedge is just that ... to hedge against an unacceptable risk. If one didn't anticipate rough sailing ahead, or if one wasn't facing some other circumstance that precluded sale of an asset, one would remain unhedged. But there are times when assets must be held in tempestuous markets . An investor, for example, who's already taken a full complement of short term losses for the year might want to hold gold mining shares until they qualify for long-term capital gain/loss treatment.
There's no presumption in the presentation that alpha is positive. Excess returns can be, and as we've seen often, ARE negative. In this case, a negative alpha would be symptomatic of management's failure to beat the performance of the gold market. Beta's a matter of perspective. There are, in fact, TWO betas associated with gold mining stocks: equity risk, which can be hedged with a stock index product AND gold risk, which is addressed by DZZ. There's still plenty of beta in Hecla even after hedging with DZZ.
As for taking a "married" position (gold mining issues plus DZZ) at the outset, that's purely an alpha play. You'd be treating the mining issue as you would ANY equity issue. If you were looking for gold performance, buying gold itself would be more efficient.