Does Downside Protection for Precious Metals ETFs Make Sense?

Earlier this week in Forbes ("Commodities Could Consolidate But Precious Metals Bull Rages On"), Addison Wiggin quoted veteran investment newsletter publisher Richard Russell on the bull market in precious metals:

Because the precious metals are in a massive bull market, many eager amateur analysts are now trying their hand on calling ‘the top.’ This is a hopeless and ridiculous endeavor during a powerful bull market.

Much of this top-calling is done by an anti-gold element: Those who dislike gold or those who have missed the entire gold bull market. My advice all along has been to ‘ride the bull’ and to ignore the ‘top callers.’ Stay invested in the metals until they exhaust themselves in panic buying.

Russell was right about the difficulty of timing the top of a bull market. But precious metals longs have more options than just deciding whether to stay invested in precious metals or take profits -- in some cases, they can also hedge. Not in all cases though.

Some precious metals ETFs and ETNs -- among them, ETFS Physical PM Basket Shares (GLTR), ETFS Physical Platinum Shares (PPLT), ETFS Physical White Metals Basket Shares (WITE), iPath DJ-UBS Precious Metals TR Sub-Index (JJP), and UBS E-TRACS Long Platinum TR (PTM)-- don't have options traded on them, so they can't be hedged directly with put options.

A few precious metals ETFs do have options traded on them, though, so they can be hedged. Does it make sense to do so? As always, that depends in part on the cost. In the table below, I've listed five precious metals ETFs, along with the cost (as of Monday's close) of hedging each of them against greater-than-20% declines over the next several months, using the optimal puts for that. First, a reminder about why I've used 20% as a decline threshold, and what optimal puts means in this context.

As I noted in a previous article on hedging, the threshold I usually use when I hedge is 20% (i.e., I want protection against any decline worse than that). The idea for a 20% threshold came from a commentfund manager (and Stanford finance Ph.D.) John Hussman made in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Hussman was referring to equities there, not precious metals ETFs, but 20% still seems like a reasonable threshold to me -- large enough that it reduces the cost of hedging, but not so large that it precludes a recovery. When hedging, cost is always a concern, which is where optimal puts come in.

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. With Portfolio Armor (available in Seeking Alpha's Investing Tools Store, and as an Apple iOS app), you just enter the symbol of the stock or ETF you’re looking to hedge, the number of shares you own, and the maximum decline you’re willing to risk, (your threshold). Then the app uses an algorithm developed by a finance Ph.D. candidate to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

One figure jumps out immediately in the table below: the cost of protection against a >20% decline in SPDR Gold Shares (GLD) over the next several months is only 0.28%.

In his Seeking Alpha article earlier this week ("Using History to Determine Gold's Intrinsic Value"), John Tobey made a well-reasoned case that "today’s gold price carries high risk." Given the low current cost of downside protection on GLD, if I owned that ETF I would strongly consider hedging it with the optimal puts.

Symbol	Name	Cost of Protection (as % of Position value)
GLD	SPDR Gold Trust	0.28%*
SLV	iShares Silver Trust	4.6%**
DBP	PowerShares DB Precious Metals	1.43%**
SGOL	ETFS Physical Swiss Gold Shares	1.24%*
SIVR	ETFS Physical Silver Shares	3.47%*

*Based on optimal puts expiring in September, 2011.

**Based on optimal puts expiring in October, 2011

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.