Money: Turning Gold into Money

What does one do in a flat or even falling gold and silver market? Some will panic and sell their holdings. Others will view lower prices as a great buying opportunity in anticipation of higher prices in the future.

It seems reasonable to assume that the long-term trend for the precious metals will continue to be up, but it is difficult to say when that will become evident. The Reagan election has fostered great hopes for the American economy that have overcome doubts about his potential impact on the level of world tensions. The new administration could reduce taxes and regulatory burdens, in the process stimulating productivity and lowering inflation. But this will be a tough row to hoe, especially since Reagan has set a stern course toward an expensive military buildup. In any case, structural inflation has a momentum of its own.

Things are bound to be better than if Carter had been reelected. But when it becomes apparent sometime next year that inflation will not be routed in landslide fashion, those ever-cynical bullion markets are sure to register that realization—other things like basic supply and demand for metals and world peace being equal (which they never are). With prices moving lower at this writing, however, and likely to at least remain quiet for awhile, what does one do with his precious metal holdings right now? Those who are disinclined to divest themselves and who may even want to add to their holdings at lower price levels do have some little-noticed alternatives—some options, to be precise.

Anyone who has ever considered buying "call" options on gold or silver knows that the premiums are quite high on these rights to buy metal at a certain price within a specified length of time. But, looking at it from the option seller's point of view, the very fact that premiums are so high presents an interesting investment strategy. Anyone with a minimum of 100 ounces of gold or 1,000 ounces of silver can "write" call options on his holdings, through a broker, with options dealers like Valeur White Weld and Dowdex (for gold) or Mocotta Metals (for silver). You thereby give the purchaser of the "call" the right to buy your gold or silver at an agreed-upon price with a certain period of time (usually three months). You risk losing your metal, but you also get respectable income, while limiting your own potential losses from a fall in price.

"We believe you should own precious metals, because they have proven to be the only true money to own," says Michael Boyd, Jr., vice-president of Crucible Securities Management of New York. "But the case for options is that, since precious metals are a nonearning asset, in a flat market they are an expensive asset to own." Not only does the owner forgo the returns available on other investments; he pays storage and insurance costs. Crucible, which manages investments for the Deak-Perera Group, seems to be the leading exponent and practitioner of gold options writing at the moment. William H. Miller, the firm's treasurer, says that premiums on gold and silver options are now so high that writing calls on one's gold is a low-risk way to "convert a nonproductive asset into an income-earning asset."

Annualized returns on options writing have sometimes approached 40 percent, according to Boyd. He recommends that "you write options against only half of your metal in order to generate enough income to make it attractive to hold your metal on an overall basis." As an example of how this intriguing play might work, assume that you had bought 100 ounces of gold at $600. (If you had bought it at $100, so much the better.) So your cost is $60,000. Let's say you write a three-month call option with a "striking price" of $660 for a premium of $30 per ounce. To start with you would receive an immediate premium check of $3,000. That, in effect, makes the cost of your gold $57,000. Should gold rise above $660 within the three-month life of the option and the purchaser of the option exercises his right to buy your gold at $660, you would sell your gold for $66,000.

In this example, your upside potential is $90 per ounce, and you are protected from loss up to $30 per ounce (this does not include brokerage fees). If, during the life of the option, gold did not move enough to put the option "in the money" for the buyer, you received good income on your gold and avoided delivery.

In order to play the options game it is necessary, first of all, to have at least 100 ounces of gold or 1,000 ounces of silver, for all options must be fully collateralized. You cannot "short" the market. It is also necessary to place your gold in a warehouse approved by the guarantor of the option's performance. Although the major gold options market is in Switzerland, it is ordinarily possible to arrange storage and even delivery in the United States.

Despite the income-earning potential of call options, some people might not be comfortable with the risk of losing their gold if the option is called. Dr. Wray A. Kunkle, who trades commodities for Wheat First Securities in Washington, suggests an alternative method of hedging a stagnant or falling gold market. "I'd rather buy 'puts' (rights to sell at a certain price) on Homestake Mining shares," says Kunkle. "It's much safer. If you're really bearish on gold, you can buy puts on Homestake, and you can sleep at night. Nobody is going to take your gold. It's the least expensive insurance policy around." In mid-November, Kunkle notes, with Homestake selling at $74, April puts with a striking price of $50 were selling at 15/16 ($93.75 per 100 shares).

Selling calls on actual metals is only plausible, contends Kunkle, if you are convinced that gold is either going straight down or sideways. In reality, he added, the gold market is extremely volatile, and wild price swings could unexpectedly activate a call option.

Boyd demurs from the Homestake "put" idea. "They're not the same—apples and oranges," he argues. "Homestake is a piece of paper. The vagaries it is subject to are not quite the same as the metal." Moreover, Boyd contends, since Crucible advises its clients not to write options on their entire gold holdings, their own scheme makes sense. "The income is so large in the short term that you could risk losing gold at a comfortable price," says Boyd. "And you would anticipate buying it back," he adds, at an attractive level.

Anyway, who says gold can't earn income?

Steve Beckner is a free-lance financial writer, the editor of Deaknews, and the author of The Hard Money Book.