Hedge Your Hedge in Precious Metals

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Tensions around the world continue to mount. The move toward oil and commodities grows as equity bulls begin to hesitate. Those looking to hedge against both geopolitical fears and inflation are using precious metals. Gold and silver have become the playmates of fear, whereas palladium stands a bit more on its own and platinum's performance is tied more to the economy. The ETFS Physical Precious Metals Basket Shares ( GLTR) wraps these four metals into a single basket. Fortunately if you're looking for a hedge against equities, platinum and palladium make up only about 13% of the ETF. Normally, I would consider simply using gold and silver only, but the resilience of equities and weakness of the U.S. dollar make the inclusion of platinum and palladium a very attractive part of this hedge or portfolio inclusion.

With the unknowns of war and peace come volatility in equities and precious metals alike. Even though we've seen some volatility in precious metals, the more pervasive notion has been the trend. So rather than just buying GLTR outright, I want to examine a long/short strategy that could serve to mitigate some of the volatility in gold and silver, or as a hedge that could mitigate a trend, depending on a trader's outlook.

Leveraged ETFs draw their strength from a trending market, while a volatile market has a negative impact on their longer-term performance. One way to combat either situation is by pairing GLTR with some leveraged ETFs of the underlying holdings. In order to combat volatility within gold or silver (or both), a trader could approach a trade in the following manner:

Let's suppose a trader intended to buy $1,000 worth of GLTR; the underlying makeup would be roughly $454 worth of gold, $412 in silver, $81 in platinum and $53 in palladium. How could one maintain similar exposures, but perform better if gold and silver were volatile in their price patterns? Good question. One possible solution is to increase the purchase amount of GLTR to $2,000, thus doubling the dollar exposure to all the metals. Then the trader could short $227 of the ProShares Ultra Gold ( UGL) to offset the additional $454 of gold exposure in the increased purchase of GLTR, and short $206 of the ProShares Ultra Silver ( AGQ) to offset the additional silver exposure.

This model would generally outperform a straight purchase of just the GLTR shares if we experience volatility and price oscillation in gold, silver or both. The weightings of platinum and palladium are both increased, so that should be taken into account, as they would now make up about 26.8% of the holding, but that is also a level I find more responsible and desirable.

The past three months would seem like the worst time to be short a long leveraged ETF in precious metals. In fact, UGL has outperformed the SPDR Gold Trust ( GLD) by almost exactly 2 times, which is its daily leverage mandate, whereas AGQ has performed about 2.5 times better than silver. But even in that environment, this setup performed slightly better than just a purchase of GLTR alone. Obviously, the slight outperformance was due to palladium, but I believe there will still strong performance in both palladium and platinum going forward. Also, if this is a hedge against fear, inflation and even equities, then slightly longer positions in palladium and platinum should offset some of the underperformance in gold and silver if the economy strengthens and the bullishness wanes for "safe haven" plays in precious metals.

For those looking to increase the GLTR position to $2,000, but believe a trend -- whether it be bullish or bearish -- is likely, then a simple flip can be done. Rather than shorting shares of UGL and AGQ, a trader would buy the corresponding dollar values from above in the ProShares UltraShort Gold ( GLL) and the ProShares UltraShort Silver ( ZSL). If gold and silver continue to move higher in a trending fashion, then the daily reset will result in these falling at slower than a 2-times rate over a longer period. If gold and silver were to fall in a continuous and trending fashion, then these two positions will see performance close to the 2.5-times performance AGQ has shown over the past three months. Either way, a trend will most likely result in better performance. Of course, in either scenario a trader could use longer-dated deep in-the-money calls or puts rather than going long or short shares. I especially prefer the use of puts over shorting shares if the cost of time is reasonable. It's something to keep in mind since shorting leveraged ETFs involves borrowing costs and call-in risk.

Hedges are useful tools for many portfolios, but sometimes our hedges can be just a bit better if we hedge them as well.

At the time of publication, Collins was long AGQ puts and short ZSL calls.

Timothy Collins has worked as a financial adviser since 1999, focusing on portfolio customization, with a concentration on correlation arbitrage and risk-managed growth. He started Collins Capital Advisors in 2007, which has evolved into TangleTrade Management, LLC. TangleTrade is an RIA firm dedicated to formulating customized risk-managed investment strategies for individuals and small businesses. TangleTrade Management now manages the TangleTrade Fund, a correlation arbitrage hedge fund utilizing the trademarked InterETF strategy.

Prior to joining his first firm, American Express Financial Advisors, in 1999, Collins worked as a staff accountant for United Information Systems in Bethesda, Md. He has also worked as a financial analyst for Securities Pricing and Research in Annapolis, Md. Collins is a graduate of McDaniel College (formerly Western Maryland College), with degrees in business administration, economics and sociology and is a winner of the Bates Prize.

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