How can we magnify our gains from gold and silver investments using leverage?

In the investment world, leverage provides a way of potentially increasing the return on your initial investment and leverage comes in a number of forms. As well as magnifying your gains, leverage also magnifies your losses and with some forms of leverage it is possible to lose more than you originally invested. Although taking risks may not be appealing to those who wish to preserve their wealth, doing nothing and just staying in cash is not an appealing option as noted in the posts about inflation and cpi.

Given that risks do have to be taken, can we manage those risks appropriately?

When it comes to the precious metals markets, leverage comes in multiple forms:

  • Get a loan to buy physical gold
  • Gold ETFs on margin
  • Leveraged ETFs/ETNs
  • Options/CFDs/Futures
  • Mining stocks
  • Private placements

1) Get a loan to buy physical gold

It is generally difficult to obtain a loan to buy physical gold. Banks are unlikely to lend to you for this reason. You might be able to get a small personal loan but it is unlikely to be in significant amounts. In fact in 2012 the Reserve Bank of India actually banned banks from providing loans to customers to buy gold in any form.

If you were able to get a loan, then in order to profit, the gains would have to exceed the loan interest plus the premiums and the storage fees.

2) Gold ETFs

Another option is to use gold ETFs on margin. Margin is essentially a loan from the broker and these vehicles provide ways to trade the gold price in either direction up or down. There are long or bull ETFs that increase in value as the gold price increases. Inverse ETFs increase in value as the gold price goes down. Since a loan is involved, interest charges are incurred and overall this is NOT recommended for beginners or those who are risk averse.

3) Leveraged ETFs

For those who don’t want to use margin another, possibility is using leveraged ETFs or leveraged ETNs. Below are some examples of two times long and two time short ETFs or ETNs.

  • 2x long ETFs = UGL, FSG
  • 2x long ETN = DGP
  • 2x short ETFs = GLL, ZSL
  • 2x short ETN = DZZ

In theory, if the gold price went up say ten dollars then the UGL ETF would go up twenty dollars. On the surface this all sounds great and easy and these investments therefore do attract beginners. However, these are synthetic financial instruments that don’t hold any of the physical assets so doesn’t in any way represent gold ownership. The other thing to note is that these returns only apply on a daily basis. They don’t aim to track long-term changes and so they are really only suitable for very short-term trades. As a result these are not suitable for beginners.

Drawbacks of margin or leveraged ETFs

As well as being required to pay interest on the margin, ETFs incur management fees (also known as the expense ratio) and these fees are more expensive for the leverage funds because they have to account for the cost of the leverage and for active rebalancing. Over time, the expense ratio erodes the amount of gold that each share represents. Particularly with leveraged ETFs, the daily rebalancing means that these are not places to park your wealth. They should be considered as vehicles for very short-term trades.

ETF decay (Source intrino)

Decay is an important issue to consider with ETFs. The chart above on the left shows how beginners envisage a leveraged ETF to work. Here, the underlying ETF goes up by a certain amount as shown in blue, and the leveraged ETF goes up by three times as much. Although this is true over a single day, it is not the case over longer time spans. Remember that rebalancing occurs at the end of each day, prices are volatile, and leverage is in play for the losses as well as the gains. For a standard stock, if you lost fifty percent you would need to make a hundred percent gain just to get back to where you were and break even and this is magnified with leverage. The chart above on the right shows that volatility and the daily rebalancing leads to decay over time and so the worst case scenario is if the underlying ETF is volatile and range bound. We can see that the associated leveraged ETFs do badly over time.

4) Options trading

Leverage can also be obtained through options, Contracts for difference (CFDs) and futures trading. One options contract gives you control of 100 shares. You can therefore trade with a lot more shares for a given amount invested. There are multiple strategies that options traders use, based around puts or calls. It is really important to determine the risks for the particular strategy that you do use because for some strategies, the loss potential is limited to the amount invested whereas other strategies have potentially unlimited losses with a risk of losing multiples more than that originally invested.

The big difference between trading options and trading shares directly is the time factor which adds another dimension and additional risk. For example, if your stock price doesn’t move before the options expire you would you would still lose because of the time decay.

5) Mining stocks

A completely different form of leverage can be obtained by owning gold mining stocks. With gold mining, the costs for the company are generally fixed although energy costs will be an important variable factor. However, the revenue is variable due to fluctuations in the gold price. Therefore, for unhedged miners a modest rise in the price of gold can result in doubling or tripling of the company’s profits and hence that’s going to boost the stock price significantly. This is a very different form of leverage to the type that we have discussed so far and the risks are also very different. For gold mining stocks, the risks are those that are associated with mining, which is a tough industry. Risks include geopolitical risks, management issues, climate issues such as flooding, and geological risks. None of these risks are under your control and even the best mines can be affected by these problems. Despite these risks the gains can be substantial.

Returns for gold vs gold miners in gold bull markets (Source: Legacy research group)

The chart above shows how in the last four gold bull markets, the gold mining stocks have outperformed gold substantially.

6) Private placements

An alternative way of leveraging the gold price is through private placements. In a private placement, a company issues new shares and those new shares are sold privately. Those shares are not freely tradable but must be held for a specific period of time and can only be sold once the trading restriction has been lifted. The leverage aspect of this comes where at the time of the private placement, you can negotiate the acquisition of warrants along with your shares. The catch with this is that you do have to be an accredited investor to participate in a lot of these arrangements but there are some mining stock newsletters that or do offer ways of getting into private placements.

Conclusions

Overall when you are considering the different forms of leverage, you do have to select the type that fits with your risk tolerance. The different types of leverage do have different potential losses and that is really important to consider. Having a complete strategy for your trade is also very important when you’re using leverage, as well as considering the proportion of your investment pot that is going to be leveraged. Leveraging your whole portfolio would not be prudent form most retail investors. One options would be to titrate the proportion to the level of risk (i.e.the greater the risk the smaller proportion of the portfolio that would take up).