“What we thought was a wall of liquidity, turned out to be a wall of leverage.”

— Paul Davies in the FT, quoting “a number of senior bankers…”

Wanna know why your stock market shares keep on tumbling, right back to what one Fox News anchor just called “the absolute lows” from the end of last week?

It’s credit — or rather, the lack of it.

The U.S. bailout, European unity, Gordon Brown’s sainthood, every new mortgage application…all these things now look incredible — quite literally unbelievable — against the stark backdrop of no credit, no leverage today. But nothing lacks credibility like trying to make fast money in finance right now.

Even David Einhorn, the baby-faced card sharp running Greenlight Capital, cost his clients more than 12% of their money last month. And he’s the guy who spotted and bet on Lehman Bros.’ looming collapse 14 months earlier!

On the long side alone, “the 50 U.S. stocks to which hedge funds are most exposed slumped 19% in September, according to research by Goldman Sachs, while the S&P 500 fell 9%,” writes John Authers in the Financial Times.

“In contrast, the stocks that had a low concentration of hedge fund ownership lost just 2%.”

Playing the same hot-money trades as leveraged investors, in other words, will hurt and hurt badly as they’re forced to quit. “Much of last week’s selloff was driven by weak hedge funds that were forced to sell because their clients wanted out,” reckons Jim “Crazy” Cramer at CNBC.

“And since you can’t give them stock, you have to liquidate…you have to sell your stocks to give ‘em the money…if you’re a hedge fund that’s faced with redemptions.”

For once, Cramer’s just about got it right, and for every dollar of leverage, you can account him right by another multiple of gearing. Hedge funds are either closing their trades and sitting in cash, or closing their trades and giving the cash straight back to investors — instead of facing lawsuits and bailiffs demanding the Ligne Roset desks, Yang sofa, and that box at the New York Met’ in its place.

At the start of last year, the credit extended to clients of New York Stock Exchange members broke all-time records, beating even the huge Tech Stock top of March 2000.

Margin trading kept setting new records through to July ‘07, just one month before the credit crunch first ushered in the liquidity crisis, then the banking crisis, solvency crisis and now the Great Crash of Oct. ‘08.

It’s since shrunk by one quarter. The S&P index has dropped faster still, down by more than one-third in the last 15 months, and fully 42% lower from the top of this time last year.

But hey — “I wouldn’t necessarily say that leverage equates to risk,” as an NYSE vice-president said to the Wall Street Journal at the very top of “peak leverage” in U.S. stocks.

Here in London, meantime, spread-betting bookies — those financial brokers serving Joe Public with gearing (and the only bookmakers whose credit is recoverable by U.K. law) — are being forced to squish their own business, charging massive overnight interest rates on open positions even as new gambling slows.

Why? Because they’re struggling to raise funds to cover their own cost of carry, trying to lay those bets off with futures and options. It’s a new game altogether for even the biggest firms; as late as 2006, one leading spread-broker made money from 96% of its clients during their first 12 months on the book. Why bother to hedge when leveraged retail investors were so consistently wrong?

But now the cost of rolling a £1-a-point bet on the Pound vs. the Yen, to name one example, just went from zero to £6.60 ($11.50) per day at one leading broker. Rolling Spot Gold with the No.1 broker now costs some 0.15% per night of the total outstanding consideration.

That only makes owning the metal with no leverage or credit more appealing again (not least if you get Gold Stored Securely Offshore, with insurance included, for just 0.12% per year). Because the trouble with leverage is that it will bite your legs if you keep trying to ride it.

Just ask Jim Rogers — the legendary commodities bull — how his great calls on oil and natural resources paid off when his broker, Refco, went bust in 2005.

“The big proprietary desks with huge leveraged positions will be diminished,” reckons Jamie Dimon, the head and mastermind of J.P.Morgan’s government-backed bailout takeovers (first Bear Stearns, then WaMu).

“Some hedge funds will [also] find it harder to make the same level of profits.”

The loss of credit, however — and therefore the downside of leverage — is hitting different markets and thus different investors and profits at different speeds.

The total volume of Nymex crude oil futures and options, for instance, quintupled in the 10 years to Jan. 2008. Between the invasion of Iraq and the fall of 2006, its path pretty much skipped together with the path of crude oil prices step-for-step, too.

But while the oil price then took a breather, waiting almost 12 months to stop panting and push higher again, the volume of oil derivatives — the “open interest” as it’s known — spread like bind-weed, swelling by one-half its size before oil next made a fresh top.

Does that put oil in the running for a bubble that’s burst? So far, the price has sunk by almost one-half…while the open interest in Nymex contracts has shrunk by only one-eighth.

Compare and contrast that leverage — a four times gearing of derivatives shrinkage with the fall in front-month oil prices — with what’s happened to gold.

“Given all the volatility in the markets recently, why isn’t gold acting as positively as we might expect?” asked a CNBC anchor late last week.

Her interviewee — one Jurg Kiener, head of Swiss Asia Capital, a Singapore-based investment fund — might have pointed to BullionVault’s story Ghouls, Gold & the Stock Market (Feb. 2007) for the answer. Failing that, he might have at least checked the numbers and reported how Connecticut and Mayfair hedge funds are fleeing the market, as you can see in this chart.

Yet bizarrely instead, he claimed that “[in] the paper market on Wall Street…bankers continue to gamble” on gold. Which they don’t — not compared with their gambling of January ‘08. (He also claimed — twice — that the London Metals Exchange (LME) trades gold-bullion futures, which is so wrong it hurts…)

Truth is, open interest in Comex gold futures and options has shrunk by one-third since the start of this year. And while the underlying Spot Gold Price has taken a tumble right alongside, the drop from its top now measures less than 18%. From the peak of Gold Futures betting, the price of physical gold has slipped less than 7% — showing just how strong the bid for actual metal remains.

“The tulipmania, part of speculative excitement over many objects [in the late 17th century], was fattened on personal credit,” Charles P. Kindleberger reminds us in his Manias, Panics & Crashes (2000). “John Law [of the Mississippi Bubble] had his Banque Générale, later the Banque Royale; the South Sea Company, the Sword Blade Bank…

“The 1920s saw development of installment credit… From 1977 to 1982, shares and real estate were bought and sold on the Kuwaiti Souk al-Manakh with post-dated checks running into billions of dinars.”

In short, “speculative manias gather speed through expansion of money and credit or perhaps, in some cases, get started because of an initial expansion of money and credit.”

No credit, no leverage, in contrast, only comes to appeal after the bubble has burst. Finding an asset class which can then bear “demand destruction” amongst its leveraged buyers might just pay off as inflation inverts in all other prices.

Regards,
Adrian Ash
October 22, 2008
BullionVault

Peak Leverage was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

You tell yourself that these things are not fundamentally bearish for gold prices. One of them is even bullish. But you know that gold is probably due for a correction anyway, and any one of these, or other factors, is just as good an excuse as any fundamental when confronting a risk-averse crowd.

What do you do? You could weather the storm. You’re in for the long term, right? The trouble is gold stocks can fall a lot during even a typical correction.

Most everyone already knows that markets do not go straight up. If every dip led to higher and higher highs, nobody would ever lose sleep over it. Trouble is, the company could always screw up, or one of those dips could turn into a bear market. I have seen the conviction behind many buy/hold strategies melt at the tail end of a normal correction, just because it corrected invariably worse than expected.

In my observations, investors are more likely to get bucked off a bull market because one of the corrections discourages them than because they took some profits by selling into strength.

Goldcorp, one of the world’s largest miners today, has already seen three corrections of 40-50% on the way up to $45 from its $3 (split-adjusted) share price back in early 2001. That’s a 15-bagger! And it’s not over. Goldcorp will see a few more like corrections, and maybe one that’s even larger, on its way to $150. Hardly anyone who bought at $3 will still be aboard, and even fewer will sell the top:

However, there are ways to improve your long-term returns and reduce the impact of market volatility on your portfolio without ever having to trade in and out of your shares and risk getting bucked off the bull too early. Options! Options allow investors to take advantage of leverage and limit their risk.

They represent a way to benefit from most of the change in the value of the underlying property or shares without ever having to buy. Due to this leverage, they can sometimes increase hundreds and thousands of percent in the space of a week, or even a day, as in the case of Bear Stearns put options when the stock halved that fateful Friday before last. Consequently, they don’t draw only speculators; they draw gamblers ready to stake the farm on getting rich quick by abusing the available leverage.

But gambling is in the method. If you don’t know what you’re doing, you’re gambling. Otherwise, you are speculating, hedging or investing.

Today, I am going to show you how to “insure” a portfolio of gold stocks emulating the Amex Gold Bugs Index (HUI) against an intermediate correction using a few basic option strategies. “Intermediate” just means like any of the other four-five corrections that are most evident in a chart of the seven-year bull market to date.

They averaged 10-15% prior to 2005, but with the accelerated rallies post-2005, they are more likely to look like the 27% correction in 2006 from now on. A correction in the primary (seven-year) sequence would be more like 40-50% or more, which I’ve judged a low-probability event from these levels.

In any case, the first thing to do is nail down a few scenarios you think are likely. That is, try to quantify the risks. Let me walk you through some scenarios.

If last week’s sell-off is the beginning of an intermediate correction in gold prices, which is possible, gold could fall back into the $700-800 range and/or remain range bound until next year.

The “tape” is telling us this IS the likely scenario. The gold stocks traded up with gold, but they lagged it, as if they were tired. And not all of them participated. Many of the juniors sat out the last $300-400 gain in gold. The breadth of the advance was thus narrow and the leadership extended. And the way gold prices came off their peak is itself often a bearish marker, indicating more of the same to come.

I’m assigning this scenario a 35% likelihood and a 10% chance of something worse. The most likely (55%) scenario, in my outlook, is that the bulls will hold the line at the $850-900 level for a few weeks and then continue their unfinished business — i.e., developing a real top well above the $1,000 barrier.

But that analysis goes beyond the purpose of this article.

If you think the likely scenario is an intermediate correction, or worse, the easiest option strategy is to “write” (or short) a call. Writing calls is effectively the same as shorting them, except that options are contracts representing but a “right,” so the short seller is technically the underwriter of the contract. If the underlying asset goes up, he will have to either buy the calls back higher or deliver the asset(s).

If you don’t own the asset, it’s a naked short, and the theoretical risk is unlimited. If you own the asset, your risk manifests in the form of reducing or limiting your profit on the underlying position. Since we are talking about insuring a portfolio of gold stocks against a correction, we are talking about the latter.

In our hypothetical scenario, with gold falling to $700-800, the HUI might fall to the 350 level, plus or minus 25 points — which is about 90 points (or 20%) below the current level of about 440.

A note of caution: In this example, I am assuming that your portfolio of gold stocks mirrors the HUI; if it does not, you are better off writing those calls on the specifically optionable stocks in your portfolio.

Otherwise, there can be no assurance that your risk will be limited.

Last week’s bid on the Amex Gold Bugs Index (HUI) 375 September 2008 call was around $8,960 per contract — or $89.60 per each hypothetical index share. This means that if the gold share index falls below 375 before the option expires in September, you can pocket that entire amount less commission and time value. You start losing money on your underlying position only if the HUI falls below about 350:

439.05 – 89.60 = 349.45 (or approximately 350)

If the index falls less than expected, say to about 400, you might make between $20-60 points per hypothetical index share, depending on days left to expiry, which would likely cover the correction.

The downside is that gold shares brush this correction off and continue to truck higher, in which case you do not participate in any of those gains until and unless you close out your short call position.

It would not be advisable to buy puts in this situation, because premiums are too high to protect you against an intermediate drop, at least in the index. The September 2008 HUI 435 put was offered at $54 on March 20, which means it would cost you about 13% to protect your portfolio from a 15% correction.

It only makes sense to buy a put to protect your portfolio from a much larger correction. If you thought the gold share averages were in for a nasty 40% or more decline, then it would make sense. Effectively, it would protect your portfolio against any losses that exceeded a 20-25% correction.

The nice thing about options is that they are flexible. There is a myriad of strategies available to suit almost any situation. You could write the September 2008 375 call and buy the September 2008 375 put, which would net about $5,900 per contract and cover most of your downside, but eat into your gains more.

Alternatively, if you’re not so bearish, you could write an out-of-the-money put…

Regards,
Ed Bugos
March 26, 2008

Investing in Gold Options was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.