Black Swan Alert: Using Gold and Options for the Ultimate Inflation Hedge

NEW YORK (TheStreet) -- Last week the Federal Reserve published its aggregate reserves report, known as the H.3. On table 2 it shows the United States monetary system broke an ignominious record: The monetary base just barely topped the $4 trillion mark.

We crossed the $2 trillion mark back on Jan. 12, 2011. In just over three and a half years, the Federal Reserve has literally doubled the monetary base. Take a deep breath.

Granted, very little of this has entered circulation. Almost all of it is in excess reserves. Three and a half years ago, excess reserves had just crossed $1 trillion. They are now $2.6 trillion. That means, of the $2 trillion printed over the last 42 months, only $400 billion has entered circulation. That's about 20%. The rest has done nothing but pad megabank balance sheets.

What does this mean? More inflation. What can you do? I'll explain.

The Federal Reserve is now chaired by an avowed inflationist, Janet Yellen, who admitted in 2010 that if she could she would institute negative interest rates. This is quite a dangerous situation.

Eventually that money is going to come out, but no one can say when. When it does, price inflation will become extreme. In fact, price inflation is becoming more and more obvious to the mainstream, even while 80% of the new money remains locked up.

Prepare for the Black Swan

Investing in gold, silver, miners or other commodities as an inflation hedge is one thing, but if ever this money does come out in force, a true Black Swan, a la Nassim Taleb's bestseller, will be in play.

I am a precious metals investor and I have been since the Fed started printing post-2008. But buying gold exchange-traded funds, storing physical metal, or even buying gold stocks or other commodities will not completely insulate your portfolio. If there ever really is a true dollar collapse, something a little more extreme is needed.

The move I will suggest here is not at all recommended for large positions. Assuming a porfolio of $100,000, a 1% position is enough to provide more than adequate protection.

It is generally acknowledged by both the gold bug community and the gold bears alike that if gold were to spike as it did in 1980, gold stocks and ETFs like Market Vectors Gold Miners (GDX) and Market Vectors Junior Gold Miners (GDXJ) will outperform the metal itself, but only between, say, two to five times. That's not all that much if we're talking Black Swan. While it is also acknowledged that silver will outperform gold in the event of a 1980-like spike, still, it will only outperform gold, estimating widely, at between 1.5 and three times.

A true hedge against a Black Swan will require much more protection than that. Investing in the ETFs straight up requires way too much capital to function as a good hedge in any case.

Let's use the gold spike of 1978-1980 as a basis for calculation of what is possible. On Jan. 20, 1978, gold traded at $173.05 an ounce. Just two years later, on Jan. 21, 1980, gold hit a high of $850. That's a quintupling in two years, and there were no excess reserves back then. Volcker jacked up interest rates to unprecedented levels in order to save the dollar. This time raising interest rates that high is impossible because of the enormous amount of government debt involved.

For silver, the spike was even more extreme. In January 1978, silver was trading at $5. On Silver Thursday on January 21, 1980, it hit a high of $48.70. That's an increase of 10 times, about double the rate of the gold spike.

Let's imagine, then, that a possible Black Swan that could result from an escape of $2.6 trillion in excess reserves into the economy is a quintupling of gold in a two-year time period, theoretically speaking. It won't be exactly this if it ever happens, but we're using this just as a base. This sounds ludicrous, but Black Swans always are. The less they are discussed and the more ludicrous they sound, the more they fit into the Black Swan category.

On the face of it, silver looks like the better hedge, and it would be if we were talking straight up silver investment. But let's push down the leverage pedal to the floor and see where we can get.

Looking into options and assuming a two-year timeframe, the highest and farthest out we can go at present are the 2016 iShares Silver Trust (SLV) $40 calls. The 2017s will be available in November. Those calls are on sale for 22 cents, and over 55,000 contracts have been traded so far. That's the second highest open interest of any strike expiring in 2016, so the trade is a bit crowded. What would those calls be worth in the event of a 10x spike in silver in two years? (For this calculation, we'll assume the 2017 $40 calls will be sold for a similar price come November.)

A 10-times spike would put SLV at roughly $197, making the calls worth $157 each. From 22 cents, that's a gain of 71,200%. That means that for every $1,000 you put into $40 2016 SLV LEAPS, you would get a return of $713,000. If SLV doesn't reach $40 by 2016 or 2017, you lose $1,000. That's a risk/return ratio of 713:1. Now that's a bit better of a hedge.

But still, this is not the move I had in mind. The ultimate hedge is actually hiding in plain sight, right out in the open in SPDR Gold Trust (GLD).

Go to the GLD 2016 calls and the farthest strike out is $225. Assuming a quintupling of gold in a two-year time frame (either from January 2014 or January 2015, as 2017 LEAPS in GLD will also be available come November) that puts GLD at roughly $625. $225 LEAPS on GLD are currently available for 29 cents, and only 6,688 contracts have been traded. Compare that with SLV's 55,000 and this trade seems extremely neglected.

If GLD quintuples in two years, that puts the options at $400 a contract, for a return of 1,379-times, or an astronomical 137,800%. Meaning, for every $1,000 you put into 2016 or 2017 $225 GLD LEAP options, you will have $1,379,300. That is nearly twice the return on SLV LEAPS, putting the risk/return ratio at 1379:1, and that already takes into account that gold is generally half as fast in rising as silver.

So why is open interest in GLD LEAPS at $225 only a measly 12% of the open interest in SLV LEAPS at $40, when the potential return is almost double and the risk almost the same? I'm guessing the reason is that the gold bug community that generally prepares for these types of events sees silver as a higher return vehicle than gold, which it is if you're talking about the ETFs or the metals themselves, but not with LEAP options. The gold bugs are blinded by a silver bias, ironically. The extreme dearth of open interest on these GLD LEAP contracts suggests a suppressed price as well.

The point of this exercise is not to predict exact numbers nor to say flat out that a quintupling of gold in two years will necessarily happen. I have no idea if it will. But I am saying that such a rise has happened before, and that this time there are 2.6 trillion freshly printed dollar bills stuck in a computer somewhere just waiting menacingly for something to spark them all loose.

For gold bugs and gold bears alike, GLD $225 2016 and/or 2017 LEAPS are the ultimate inflation hedge, way beyond anything else available today in terms of risk/reward. If 2016 doesn't work out, then sink in another $500 or $1,000 on the 2017's when they become available, and so on next year until the $2.6T (and counting) fly loose into the economy. With a return:risk ratio of somewhere around 1379:1, there's really almost nothing to lose.

At the time of publication, the author was long long SLV, GDX, GDXJ, and call options on GLD, although positions may change at any time.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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