Back to top

Image: Bigstock

With Precious Metals, Make Sure You're Not the "Greater Fool"

Read MoreHide Full Article

I’ve been getting some questions lately about options strategies for speculating on the price of precious metals, specifically gold.

Gold prices have been rallying lately for a number of reasons and it’s only natural that traders see an opportunity for profits in gold derivatives, using the leverage of futures and/or options to bet on either a continuation of the rally – or a swift reversal.

Here’s my short answer – I don’t know.

The mechanics of trading Futures, ETFs and options on gold prices are basically the same as they are for all similar instruments, but I don’t have any opinion at all on the likely direction of those prices.

I’ve been trading securities since 1994 and over those 26 years, I’ve traded equities, indices, interest rates, currencies and commodities. I’ve had positions in futures, options and the underlying securities. Sometimes I’ve held just relatively small positions in my personal account; sometimes I had enormous market-maker books with notional value well into the billions.

I have never once had any position – long or short – in the price of gold.

I just don’t understand it. It’s an inherently worthless asset that has value only because some people think it has value. In the early days of currency, thousands of years ago, gold was a good medium of exchange because of its rarity. A potential counterfeiter could make all the coins he wanted out of iron or other plentiful metals, but because of its obvious physical differences, gold was hard to fake.

In modern times, many investors consider gold to be both a hedge against inflation and a safe way to store value outside of the financial system. If you’re wary of the complexity of the systems that allow trillions of dollars’ worth of financial transactions around the world every day, owning gold is an opportunity to physically hold an asset in your hands.

No matter what happens, you’ll always have the gold, right? If governments and central banks act irresponsibly with regard to monetary policy and ignite runaway inflation, the value of the gold you hold will increase along with the prices of the goods and services you want to buy.

If the whole system collapses and fiat money becomes worthless, you can use that gold in your safe to barter for essential supplies and ride out the apocalypse in relative comfort.

That’s the thinking anyway, but I think there are some gaping flaws in the logic behind it.

In my opinion, the “value” of gold is almost entirely dependent on what’s most easily referred to as the “greater fool theory” - in which a speculator purchases something he knows to have inherently low value in the belief that someone else will act irrationally and buy it from him in the future at an even more inflated price.

As an industrial product, gold has almost no value. It’s heavy and soft and not very good for making anything you want – other than possibly decorative jewelry. I don’t even know how to begin to calculate how many miles of copper there are between the laptop I’m using right now and your home or office, wherever you are in the world. Copper is relatively plentiful in the world and has a huge number of uses in the things all of use every day.

Industrial prices for copper are quoted not by the ounce, but by the ton. It's very useful and very cheap.

Gold just sits in the safe.

One of the most successful investors of all time – Warren Buffett – has expressed a similar sentiment pretty much every time someone has asked him about investing in gold.

He once famously pointed out that all the gold that has ever been mined in the history of humanity could be combined into a square block that measures about 67 feet on all sides. (This was about 9 years ago, so the block is a little bigger now - but the logic of his argument remains the same.)

The cash value of that block at that time was enough to buy all the shares of Exxon Mobil (XOM) – then the world’s largest company – sixteen times over, and buy all of the farmland in the United States and still have a trillion dollars left over.

Buffett asked whether a rational investor would rather have the big shiny block or $10 trillion worth of productive assets that feed and power the world and pay dividends to the owners. If the answer is that you’d rather have the productive assets instead of all the gold, by extension, you should always make the same choice even on a smaller scale. The rational investor would always prefer quality equity or debt securities over a small hunk of soft, heavy metal.

Buffett also comically pointed out that, “Gold gets dug out of the ground in Africa or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

The Charlatan Angle

If you watch the financial news on television, you’ve almost certainly seen commercials for outfits that are willing to sell you physical gold and send it to you in the mail.

One of those ads even features a kindly, Wilfred Brimley-style actor who calmly assures the viewing public that his gold is "working for him" even when he's asleep. That's a blatant lie.

I specifically watched for one of those commercials yesterday and waited for the details of their offer. They were willing to sell me 1/10 of an ounce of gold for the low price of just $189.

Simple arithmetic shows us that that translates to a price of $1,890 for a full ounce (plus shipping and handling, of course.) That’s an 11% premium to the price of gold futures for June delivery on the Comex. The selling company obviously has other expenses – most notably the cost of television commercials – but I consider it borderline larcenous to sell a widely available commodity item at that kind of markup by preying on the fears and insecurities of less sophisticated customers.

Shotgun Shells?

I spent several years on the “Disaster Recovery” committee at a proprietary trading firm. Our mission was to brainstorm as many as the possible of the big potential problems in the world that we could imagine and then discuss whether there was a cost-efficient way to mitigate at least some of the respective risks.

We considered natural disasters, terrorism, hackers, magnetic storms, the collapse of the world’s banking system and many other more far-fetched possibilities.

For the most extreme potential events, we would sometimes simply end the discussion and informally file it away as what we called a “shotgun” scenario – meaning that if something bad enough happened, preserving the firm’s assets and capital would no longer be worth any effort. Money would cease to have value and the preferred currency would become shotgun shells to protect yourself in a Mad Max-style dystopian future of civil unrest.

That’s obviously an extreme analogy, but I think it has implications for the value of precious metal in a true disaster situation. Having a handful of that heavy, soft, shiny metal is unlikely to get you much of what you need in a true doomsday situation.

Technicals

There is one way in which I have observed traders have measurable success trading gold – using technical analysis. I generally have a healthy amount of skepticism about using only price behavior (and completely ignoring fundamental information) to determine fair asset prices.

Ironically however, it seems like the irrational nature of changes in gold prices actually lends itself to successful technical analysis-based trading!

If you tell me that a given stock is overbought or oversold based on recent price behavior, I’m going to want to know whether there’s actually a rational reason based on that company’s current or future financial results that’s causing those price changes.

In the case of gold – because it’s inherently worthless -  the prices are basically all the result of human emotion. The offsetting effects of fear and greed push the prices around and can be explained to a large degree by price data analysis.

So if you’re a technician, gold can be an excellent trading vehicle. You can basically treat it as a number that moves around that you can bet on.

If you’re really an investor however, gold probably doesn’t make much sense, even as an inflation hedge. There are hundreds of solid companies that are constantly providing in-demand goods and services to customers at profitable prices and returning those profits to investors.

You want to own those types of assets. The kind that work for you. (Yes, even when you're sleeping. Really.)

If the logic behind a trade idea relies on the Greater Fool Theory, please make sure you’re not the fool before you pull the trigger.

-Dave

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.

Interested in strategies with profit potential even in declining markets? Maybe our Short List Trader service is for you.

Want more articles from this author? Scroll up to the top of this article and click the FOLLOW AUTHOR button to get an email each time a new article is published.

 


 


In-Depth Zacks Research for the Tickers Above


Normally $25 each - click below to receive one report FREE:


SPDR-GOLD TRUST (GLD) - free report >>

Published in