Disclaimer: this strategy is for a small, individual investor, and is theoretical. This is just an opinion, and I recommend you do not take my strategy as an investment guide.  Also note, the time horizon on this type of trade has likely narrowed over the past 4 years making it impractical today, this is a longer term strategy.  Please do your own personal research- there is no such thing as a free lunch.

Earlier Zerohedge mentioned that the outstanding financial claims on Gold (iShares Gold Trust and so on) versus the real underlying units in storage at the COMEX stood at approximately 542 ounces of financial (paper) gold for every 1 real physical ounce.  For several years now I’ve considered a prudent trade to be short-selling the financial assets and purchasing the underlying real physical asset with the proceeds from the short-sale.

comex gold coverage ratio

In effect, this strategy would have offset most of the losses posed by the rising US dollar, while increasing portfolio exposure to the real underlying asset while navigating various risks posed.  Gold is a hedge against government.

This sort of portfolio repositioning is nothing new.  For anyone who has read Warren Buffet’s the intelligent investor, which I read myself  while sitting on a train between Scotland and London, one of the most basic strategies that an investor can pursue is to reposition from one risky asset into a less risky asset. In the book, Buffet utilizes a trade from stocks to bonds (ill advised in the current market) but the same strategy would have been an excellent trade over the last few years.

How would this have worked in practice?

Let’s assume hypothetically that in Sept. 2011, sensing mania in the gold markets we decided to take out an electronic short on the iShares Gold Trust ETF.  We have $12,000 and want to keep $2,000 of it in reserve as a margin in case the market moves against our position.  The remaining $10,000 gets placed into iShares Gold as a short.  This could, in theory, be a tremendous risk to take, if $10,000 is our entire savings, but we’ll assume that this is just one trade in a diversified portfolio.

The 5 Year Gold Spot Price, courtesy of http://www.kitco.com

Sensing opportunity we enter the market at the very best time on 6th September 2011, buying in to our short position at $18.57. A 2% broker fee is extracted for the transaction fee for the position (probably overly expensive.)

No. of Shares Sold Short = (10000-10000*0.02)/ = 9800/18.57 = 257 shares

Which we sell into the market immediately.

We suspect that iShares might drop as low as $10 per share, so we will buy the shares back out of the market in increments as we drop $2. With 33% being bought at $16, 25% at $14, 25% at $12 and 17% at $10.


By 23rd March 2012 the price hits $16 and we buy 33%, so ~85 shares back:

16*85 +(16*85*0.02) = 1387.20

Total profit = 1578.45-1387.20 = 191.25

We now have 9991.25 in our account.

By 10 May 2013 the price hits $14 and we buy 25%, so ~64 shares back:

14*64 = 913.92

Total profit = 1187.28-913.32 = 274.56

We now have 10265.81 in our account.

By 2nd December 2013 the price hits $12, we buy 25% , so ~64 shares back:

12*64 = 738.36

Total profit = 1187.28-783.36 = 405.12

We now have 10670.93 in our account.

Finally by 17th December 2015 the price approaches $10 and we buy ~44 shares back

10.13*44 = 454.63

Total profit = 817.08-454.63 = 362.45

We have 11033.38 in our account.  For a total return of 10.33% over the 4 year period.

So what if we took the profits and bought physical gold in increments, taking 1/5 of the account balance at each sale date and converting it to physical gold (see Kitco data here)?

Oz Gold Bought 23rd March 2012: 1998.38/1660 = 1.20

Oz Gold Bought 10 May 2013: 1653.51/1440 = 1.15

Oz Gold Bought 2nd Dec. 2013: 1403.81/1230 = 1.14

Oz Gold Bought 17 Dec. 2015 = 5977.68/1055 = 5.67

Sum total Gold bought = 9.16 troy ounces (284.9 grams)

Where would end up with this strategy?

This final value of 9.16 Oz. contrasts with 10000/1900 = 5.26 Oz if we had bought at the Sept. 2011 peak. Or 10000/5977.68 = 9.47 Oz if we had waited and bought it all at the Dec. 2015 trough.

However, we have mitigated our downside risk with this strategy in terms of the falling price the mean time, and mitigated the possibility of not being able to purchase some (or purchasing some with a large premium on top) in the event of an unexpected supply shock. Furthermore, unlike a futures contract there is minimal counterparty risk, and unlike an option (though I am not sure options for physical delivery even exist- maybe one could be created over the counter with a bank or something) there is not a initial cash outlay and no counterparty risk.  This would also mitigate the cost of insuring, or storing the gold as inventory, or the cost of paying fees to a bullion bank to do so.

The $2000 margin could be kept as additional liquidity, or placed into new investments, or used as a final purchase if the market dropped further.

Obviously this could work for any physical precious metals, and while it is idealistic in the sense that we were looking back at historical data, I would advocate this type of strategy for converting financial to real assets in general if they are in a extended bear trend, but a longer term risk of non-delivery is present.


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