From the March 2014 issue of Futures Magazine • Subscribe!

Reduce or eliminate downside risk

Question:

How can I maintain upside exposure to gold in case of a huge spike in inflation but avoid the risk of volatility and a downward correction?

Answer:

A 1x2 call spread that is long one lower strike call and short two higher strike calls with protective short-term long calls can reduce or eliminate downside risk and allow you to participate in a large upside move.

There is voluminous academic and sector sponsored research that supports the notion that a small allocation to gold is an important part of a diversified investment portfolio. Typically recommended allocations of 2% to 12% are meant to protect against inflation, currency devaluation and various systemic risks. The most common methods of gold investment are direct ownership (coins and bars) and exchange-traded funds (ETFs). Both have specific pros and cons (see “Accessing gold,”below), but both are categorized as passive long. As such, the profit and loss (P&L) profile is linear: If the price of gold rallies 10%, you make 10%; if the price of gold falls 20%, you lose 20%. As we see it, this is potentially problematic in both directions.

Small traditional allocations to gold don’t deliver great participation to the upside. Increasing the allocation obviously increases potential losses to the downside. Simple linear gold expressions represent either insufficient upside exposure, or excessive downside risk. Non-linear expressions function as superior forms of portfolio insurance.

The prevailing environmental factors for gold: Improving economic data, a less accommodative Fed, ETF liquidations, stellar equity market performances, represent significant headwinds and challenges that may render passive long investment ineffective, or worse – detrimental.  Examining various methods of gold investment illustrates the point. 

The future looks uncertain. With equity and real estate bubbles looming around the world we are in uncharted territory.  The potential for unintended consequences of expansive monetary policies cannot be dismissed. Even the most well-researched and experienced academics and financiers cannot predict with certainty if or when the demise of the U.S. dollar will occur or how rapidly it takes place. If part of the reason for an investment in gold is to hedge against a scenario like this in an attempt to truly preserve purchasing power, then it is unlikely that passive long investment (linear P&L) will deliver a sufficient return. A tail risk payout requires leveraged upside exposure.

Of course, as readers of Futures you are familiar with the leverage available in futures and options markets. Leverage is always is a double-edged sword and can be dangerous. 

Options provide a way to access the potential upside in gold and protect against the downside moves and volatility that often kill most outright futures positions (see “Stopped out again,” below). 

An asymmetric risk/return profile, one that focuses on capital preservation when gold trades sideways or down and leveraged upside exposure when gold rallies substantially, can be achieved if crafted properly. This strategy is exactly what many investors are looking for from gold.  The beauty of options is in the variety of strategies that can be designed to achieve a specific P&L profile construction.  

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