Investment thesis: “Owning physical gold and silver is good for portfolio diversification, but the risk adjusted returns can be improved by hedging the downside risk using options.”

The purpose of this article is to explore if this statement is actually true, or if the cost of the hedge options (the “insurance”) actually ends up costing you money over time.

BTW – This is purely a trading strategy article – we aren’t going to cover the reasons why you would want to own physical precious metals (gold and silver) as they have been covered on seekingalpha and elsewhere.

Investment Drivers and Market Philosophy : The basic premise is that the long term secular trend for precious metals is up, but the sell offs can be significant and steep when they arrive (for example, Silver’s two separate 20%+ monthly declines in 2011, due to margin changes).

The other aim is to be “in the market” if it takes off significantly to the upside (e.g. swift dollar devaluation) – but this is not to predict when this will happen. This physical position will be held as part of a wider portfolio strategy – the aim not to make a quick buck, it is to manage a long term allocation to precious metals using options (theoretically with lower risk). Typically this doesn’t attempt to be a market timing strategy (e.g. For silver buy at $32.45, sell at $37.56), although we would definitely sell part of the position into significant strength (about 10% to 15% of physical position) if things look very over bought (e.g. Silver in April 2011).

Note that using options to hedge introduces some market timing as they have to be rolled between months. The option hedges should be reviewed each week, and potentially rolled once a month (depending on market conditions).

Strategy : We will maintain a significant physical position in Silver (maintained in your physical precious metals broker of choice*), coupled with an appropriate hedging strategy using the very liquid SLV ETF options. The aim is to maintain the core long physical holding (not trade it more than 2 or 3 times a year to reduce transaction costs), but hedge the month to month movements using options.

We will review a basic married put strategy using SLV options over 1 year’s of trading period. Obviously this is not statistically valid because the time period is only 1 year, but the silver price trading in 2011 was particularly volatile so at least its an interesting case study (we have back testing software for long term analysis, but that’s a much longer conversation). Also these are actual trade results as opposed to theory, so that’s always more interesting (in our opinion).

The time range is 22nd Nov 2010 to 21st Nov 2011. The physical silver position, is hedged using out of the money SLV put options every month. The hedge is typically about 5% to 10% out of the money each month with a number of put option contracts approximately similar to your physical position. For example if you have a starting Physical Position to 900 shares of SLV then this is about $24,453 = 900 shares * 27.17 (SLV close price** on 22nd Nov 2010), so hedge with 900 shares/100 = 9, so use 9 put contracts.

Results :

For reference, the Buy and hold performance is approximately 20% for the same time period – see SLV chart

Table below has gain/loss for SLV put option hedging trades only :

Note : The number of contracts decreases as the physical position is sold on market rallies (starts off the period at 9 contracts, and finishes at 6 contracts).

Ideally the % return (“performance”) of the hedges has to be described somehow, so the *could* be calculated against the original principal as follows :

hedge total gain/loss DIVIDED BY starting underlying principal

$2554.75 / $24,453 = approximately 10.5% gain

Conclusion :

The surprising conclusion is that the hedges made money ($2554.75), even though the underlying was up 20%. However you have to stomach some major downturns in your hedge performance along the way (max drawdown was -$2614.43) – however presumably you would be happy with the performance of your physical position at that stage.

In summary, if the market is highly volatile you can actually make money on the protective hedges throughout the course of the year, especially if the underlying does move around a lot (as per above results). Theortically this works is a bit like playing poker, bet (lose), bet (lose), bet (lose), bet (win big) etc – for example (not real numbers) if SLV is at 32.5, buy a March 2011 30.0 put (pay $1), SLV closes on expiration at 35 (lose $1), then buy an April 2011 33 put (pay $1), and SLV closes on expiration at 29 (make $3). The put option insurance is typically skewed towards losing many times, but when you win, you can win big.

Caveat : Please note the highly volatile market was likely the “sweet spot” for this strategy – if the market was less volatile, you would likely (on average) consistently lose your put option premium each month. It’s definitely not a good candidate for all stocks/commodities but silver turned out to be a good example for 2011.

In summary this can be an effective “sleep at night” strategy for maintaining a large position in a volatile market, and on balance we would recommend use of put option insurance – but does require some maintenance and “keeping the faith” when the put premiums expire worthless every month.

Freedom 2020 LLC

Postscript – Random Thoughts : There is a physiologically “feel good factor” to this strategy – the thinking goes: whatever ever happens we’re protected on the downside so we don’t need to pay attention to all the wiggles in the market every day, but at least we’re “in” – however the cost of the insurance can mean that over time you are giving back a lot of premium for the sleep at night “comfort factor”. Conversely, this strategy can actually help if you have a nervous investment disposition especially if you tend to be a worrier (pondering “what if” scenarios all the time).

Footnotes:

* None are named here, as we are not going to recommend any, but if you google it several are available.

** Uses SLV close prices for simplicity (not spot Silver)