Gold ETF’s have become extremely popular, as shown by the fact that ETF-driven demand for gold was higher than jewelry demand in the second quarter of 2010 according to the World Gold Council.
Yet as gold has gained a more mass market audience, it has attracted a mix of both people who genuinely want to own physical gold and those who are more interested in betting on the direction of gold prices, rather than owning the metal physically.
It’s hard to prove the exact mix of investors, but it’s probably fair to say that a larger proportion of the gold investor population is comprised of pure speculators (not your traditional, conservative physical gold investors) than, say, in 2002.
Investors who speculate on gold via ETF’s which hold physical gold have helped to increase demand for physical gold vs. supply, and this helped make gold supply tighter than it would have been otherwise.
Yet what if speculators increasingly turn to alternate methods of betting on gold prices, which aren’t limited by the physical supply of the commodity? Taken too far, it could turn the gold market upside down.
Hard Assets Investor describes a relatively simple method for replicating a gold investment out of thin air, with options:
One can obtain a long gold position (or a proxy position in gold futures, a gold trust or a mining stock) without actually touching bullion, futures or stock.
It’s done through the options market. A so-called synthetic long gold position combines the purchase of a call with the simultaneous short sale of a put, where both options share the same exercise price and expiration date. The position mimics a long gold position’s potential risks and rewards.
Now you may well ask why you should undertake something as complex as an option position when you could simply buy gold instead. The answer’s simple—it costs less. You can, for example, trim your capital commitment by as much as 93 per cent using a synthetic long position. That’s the same kind of leverage obtainable in the futures market. In essence, you can trade a futures contract without necessarily having a commodities account.
With that in mind, the paired options have the same unlimited profit potential of a long position in GLD shares and a similar downside risk. Ignoring commissions, the purchase of GLD shares at $120 puts your breakeven and your maximum risk at $120. But because of that penny credit, the options position’s breakeven and risk is actually less—$119.99—than the stock’s.
The synthetic investment they describe is nothing new, in fact you can use options to do something similar for stocks. But it’s a reminder of how the supply of gold investments could be far less constrained in the future, and how, one day, synthetic gold investments such as that outlined by HAI could dominate the gold market, over-powering the supply-demand situation for physical gold. Sound crazy? It’s already happened at times for other commodities, such as oil, thus it could easily happen for gold as well, and some might argue it’s already happened.