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Adding Downside Protection To The Gold Miners ETF

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In a post on Monday ("Gold's Bull Market"), hedge fund manager and market technician Tim Knight highlighted a breakout in the chart for the gold-tracking ETF SPDR Gold Shares (NYSE: GLD). Last month, Tim noted he was bullish on gold miners as well in the longer term, though they could face a pullback in the shorter term. For those long the Market Vectors Gold Miners ETF (NYSE: GDX), here are a couple of ways to hedge it over the next several months. 

1) Hedging With Optimal Puts

5.99% cost. Uncapped upside.

As of Wednesday afternoon, these were the optimal puts* to hedge 1,000 shares of GDX against a greater-than-15% drop over the next several months with optimal puts.

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 5.99%.

2) Hedging With An Optimal Collar

Pays you to hedge. 15% upside cap.

If you were willing to cap your potential upside at 15% between now and September 19th, this was the optimal collar** to hedge 1,000 shares of GDX against a greater-than-15% drop over the same time frame.

As you can see at the bottom of the screen capture above, the net cost of this collar, as a percentage of position value, was negative, meaning you would essentially get paid to hedge.

Note that, to be conservative, Portfolio Armor calculated the cost of this hedge by using the bid price of the call leg and the ask price of the put leg. In practice, you can often sell calls for more (at some price between the bid and ask) and buy puts for less (again, at some price between the bid and ask), so, in actuality, an investor opening the collar above may have gotten paid more than $360 to do so.

Possibly More Protection Than Promised

In some cases, hedges such as the ones above can provide more protection than promised. For an example of that, see this post about hedging shares of Tesla Motors, Inc. (NASDAQ: TSLA).

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures above come from the Portfolio Armor iOS app.

The preceding article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

 

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