I’m frequently asked about gold.
Over the years, it’s been a great investment, but lately… (sigh).
Let’s just say the shiny stuff has hardly lived up to expectations.
Part of that is due to the dynamics of the gold market itself and part of that is due to the fascination with cryptocurrencies.
Let’s talk about each of those things then move onto a great way to play gold today.
Perhaps, even the only way.
Gold has historically been driven by its relationship to inflationary expectations, to interest rates, and to physical supply. Generally speaking, gold prices move inversely to economic prosperity.
You can actually see that quite clearly when you compare the SPDR Gold Shares (NYSEArca:GLD) to the S&P 500 Index. Prices tracked almost in tandem from 2009 to mid-2012 then broke when investors finally decided that the post Financial Crisis recovery had teeth.
Figure 1 YahooFinance
Now with geopolitical concerns rising and interest rates on the uptick, many investors are wondering if gold could “shine” again.
I wouldn’t bet on it.
As of last November, The Wall Street Journal reported that retail gold sales were at the lowest levels in a decade. Mohamed El-Erian, Chief Economic Advisor to Allianz SE (ETR:ALV), even went so far as to warn that cryptocurrencies could pose a serious long-term threat to gold.
My sentiments exactly.
The situation is so bad that even gold purchasers buying directly from the U.S. Mint are reportedly getting pinched as dealers stockpile coins they can’t sell. Sales volumes have dropped off a cliff.
There’s simply not a lot of buyers, nor are there likely to be. But, that doesn’t mean all is lost.
You can still profit from gold if you know where to look and which tactics to use.
Playing Gold in “Pairs” for Profits
My suggestion is to play gold with something called a “pairs” trade.
If you’ve never heard the term before, a “pairs” trade means that you are simultaneously buying and selling shares of two different companies and treating the net spread between them as a single position.
Practically speaking, it’s no different than ordering a “value meal” at your favorite fast food joint. You’re paying one price for a burger, fries, and a drink.
Pairs trades have a number of advantages that make them ideal for current market conditions. They offer:
- Big profit potential no matter which direction the markets go next;
- Easy implementation; and,
- Minimal risk exposure.
Pairs trading has n around since roughly the early 1980s when Morgan Stanley (NYSE:MS) quants figured out that they could trade the markets for huge profits using an investing approach that did not depend on market direction.
Since then, pairs trading has become widely used by institutional traders, proprietary trading desks, and even individual investors thanks, in large part, to the Internet.
The idea is simple.
Traders use either fundamental or technical data to construct a pairs trade based on highly correlated stocks, indices, or other instruments. Usually, they’re in the same sectors or industries but that’s not always the case.
When done correctly, pairs trades are delta-neutral (meaning they don’t depend on direction), inexpensive to put on (because the short help pay for the long), and limited risk (because they’re dollar sized instead of being share dependent).
Pairs trades are also optionable which means that traders who want more juice or who desire using smaller amounts of capital can still be successful. For example, a trader could sell calls on the stronger security while selling puts against the weaker. As both revert to their statistical mean, the trader profits from time decay and price movement.
There’s plenty of verifiable third-party evidence that pairs trading is profitable.
One of the most important is a 1998 paper from the Yale School of Management by Evan Gatev, William Goetzmann, and Geert Rouwenhorst. And, one of the better, more clearly written books on the subject if you’d like a more in-depth understanding is Pairs Trading: Quantitative Methods and Analysis by Ganapathy Vidyamurthy.
The premise is straight forward.
Effectively, what you’ll be doing is matching one of the best gold stocks – Barrick Gold Corp. (NYSE:ABX) – with one of the worst – New Gold Inc. (NYSEAmerican:NGD). Put another way, you’ll be buying solid performance and selling terrible performance.
Barrick offers the best stability in the gold/metals industry and has a combined topline of $8.37 billion for 2017 that produced $1.44 billion in net earnings.
New Gold may be the worst. Price is trending lower at a time when gross margins are on the decline. In contrast to Barrick’s profits, New Gold lost $108 million over the same time frame. Operating cash flow is negative $380.7 million and the company’s gross margin has dropped roughly 31.5% over the past 10 years.
Here’s how you’d set up the trade using equal dollar amounts:
Buy-to-open 156 shares of Barrick Gold = $1,999.92
Sell-to-open 778 shares of New Gold = ($1,999.46)
The net cost, excluding commissions which vary from broker to broker, is $0.46. The “buying power effect” is roughly $4,888.40 – meaning that’s the amount by which your broker will reduce the capital you have available when you make the trade as outlined. This, too, varies from broker to broker but it’ll give you a reference point.
You track pairs trades just like you track any other investment and, not coincidentally, you apply the same sort of money management rules.
In this case, for example, you could set a price target of $0.92 for a quick 100% gain if the markets behave according to expectations and the spread widens. Or, conversely, set a trailing stop of 25% at $0.345 (thirty-four and ½ cents) if the markets go against you and the spread narrows.
Just as is the case with any investment, there are risks.
In this case, the biggies are that the two stocks run go against expectations. Barrick, for example, could have a terrible set of earnings that causes it to drop while New Gold could suddenly enjoy newfound profitability that causes it to rise.
There’s also something called executional risk. Pairs trading involves simultaneous orders so there’s a possibility that your broker may not be able to complete the order as intended. To be frank, I wouldn’t spend a lot of time worrying about that though because today’s computerized exchanges are pretty darn efficient.
And, finally, there’s the risk of a partial fill – meaning that your broker may only be able to get you part of your order. On smaller orders this generally isn’t a problem but on bigger orders in the thousands of shares it can be. That could change the calculus significantly.
In closing, pairs trading, as I am describing it, is a speculative adjunct to your normal, core investment portfolio. That means you’re going to keep risks small but keeping the amount of money at work on a trade like this to manageable levels.
I suggest using the use the 2% Rule that we’ve talked about in the past. That way you can still rack of huge gains without the risk of blowing up your portfolio if something goes wrong.
I hope you’ve enjoyed today’s article.
Until next time,
— Keith Fitz-Gerald
Source: Total Wealth Research