For most of the past decade, gold was the place to be. A disastrous housing market collapse, terror attacks in the United States and a host of additional geopolitical issues pushed the price up seemingly every year. Investors like John Paulson had huge years for clients and his gold fund was the place to be. Then something happened. The bottom fell out and the price for an ounce of gold was cut almost in half in less than a year.
For those still positive on the gold trade, Jefferies has a very smart way to play it. There are good reasons to stay involved. The U.S. government and governments around the world have printed money at a breakneck pace. This may have helped to raise asset prices, but at some point it will also fan inflation. The Jefferies team has a smart way to stay involved in gold while hedging a portfolio as the precious metal stays volatile.
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The trade is fairly simple, and in Wall Street terms it is called a pair trade. Investors are advised to be long gold and short a basket of the big gold-mining stocks. The thought behind the strategy is that the pure gold is the play, and the increasing strains put on the miners by the decline in price may continue to weigh heavily on the stocks in the near term.
In order to put the trade on with the easiest strategy and the lowest cost for the investor, there is a very simple solution. Investors can buy the SPDR Gold Shares ETF (GLD) in their brokerage account. This exchange traded fund is a proxy that is closest to measuring the actual price of an ounce of gold. The investor then sells short an equivalent amount of the Market Vectors Gold Miners ETF (GDX). This is the ETF that holds a basket of the biggest gold-mining stocks. Investors simply have a matched amount long and short to put on the trade. The additional key to putting it on this way is you only have two commissions, and of course, you do not have to buy and sell physical gold.
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The thought behind this trade is that when the price of gold starts to move higher, it will do it before the miners come out of their current slump. High mining costs, unrest in some of the volatile areas where mines are located, and often testy labor relations with unions have kept a lid on the price of gold mining stocks.
This call may really stand out now that there is a rising risk that gold miners and producers could punish shareholders like Barrick Gold Corp. (ABX) did with last week's huge secondary offering. We showed how companies like Newmont Mining Corp. (NEM), Goldcorp Inc. (GG), Kinross Gold Corp. (KGC) and others could all decide to play copycat here.
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The key for investors is to make sure to be ready to scale out of the short when the price of gold starts to move higher. Eventually the mining stocks will move higher with the price of gold, but there should be a period when gold itself outperforms and investors will have both sides of the trade working for them.
Inflation generated by years of irrational printing of currency will come. The question in reality is not if, but when. That is the hard part for investors, as there is no crystal ball on timing. The gold pair trade is an outstanding way to be in position for a move higher while protecting the downside against a move lower.