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Don't count on gold to hedge stocks

Chris McKhann (chris.mckhann@optionmonster.com)

Most of the time the hedges that I discuss are in index puts or volatility funds. But there are many other ways that people try to protect their positions, including the use of gold.

In the past gold has been viewed as a hedge against equity declines, and people still talk about it as such. However, the precious metal has become increasingly unreliable in this role and in fact frequently trades as its own risk-asset class.

The biggest issue with hedging is correlation--the problem with the old tool of diversification touted by fund managers for decades. Diversification works great until stocks start to plummet as they did in 2008 and correlation goes to 1, when your so-called diversified assets all fall together.

And far from a "safe haven" that helps offset equity losses, gold has has recently had a positive correlation with the S&P 500. The short-term correlation varies drastically, going from -0.75 to 0.9 in the last few years, but tends to be positive and currently sits at 0.73. In the last two years, it has been highest when the SPX and gold were falling together.

This is why we tend to stick with index puts and volatility products as hedges. Most volatility exchange-traded funds and notes carry "VIX" in their names but are actually priced on the VIX futures. The CBOE Volatility Index is highly negative correlation with the S&P 500, now running at about -0.8, and very rarely turns positive.

The negative correlation between the VIX futures and the S&P 500 is even higher. So despite its structural problems , we can use the iPath S&P 500 VIX Short-Term Futures ETN (VXX) as a proxy because it is composed of the two nearest-month VIX futures.

The current correlation between the VXX and the SPX is -0.98 and has only gone positive briefly on just a couple of occasions. And that correlation remains very high when equities are on the way down.

Finally, there are stock index puts. They obviously include a VIX component, as the VIX is calculated using the implied volatility of S&P 500 options, but they also have "path dependency"--a directional component. This may seem obvious, but there are occasions when the S&P 500 falls on low volatility, so SPX puts would make money while VIX calls would not.

Which leads us back gold. While buying the metal itself may not be the best hedge, right now buying gold volatility may be an interesting play.

The VIX may be relatively low, given the "fiscal cliff" and other considerations, but gold volatility is even lower. The average implied volatility for the SPDR Gold Shares ETF is 12 percent, a record low and half of what it was in June, which happens to be when the S&P 500 was at its 2012 low.

So buying volatility in the GLD, maybe in the form of a straddle or strangle , is an interesting play right now and might be an additional hedge. However, as with all hedges, remember not to overdo it .

(A version of this article appeared in optionMONSTER's Options Academy newsletter of Nov. 28.)

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