Saturday, November 24, 2007

There is Another

If you are a regular reader of this blog, you are aware of my extremely pessimistic forecast for the American dollar over the next few years. If you are still not convinced the coming collapse of the dollar is inevitable, or if you have at any time in the last four or five months looked at your brokerage account statement and thought to yourself, "Thank God for my Google (or Apple) stock, because everything else I own is going down," then please read this, this, and this before it is too late.

As a regular reader, you are also now well armed to take action to not only preserve your capital during the ongoing destruction of the standard of living of the average American family, but to also prosper as others suffer. I want to state quite clearly that I am not happy about these ongoing events of historical significance that are being ignored by the mass media in favor of the latest developments in the lives of Paris Hilton, Lindsey Lohan, Brittany Spears, OJ Simpson (again!?), and Natalee Holloway (oh wait, she's still dead), and I sincerely wish that I could instead post regularly about ways to make money by investing in America. It greatly saddens me that I cannot do so. Unfortunately, we are way past the point of no return of America's decline as a great power, and it is critical to focus on taking action now to protect you and your family from being sucked under by the coming economic hard times.

By the time Americans go to the polls next November, we will be in the midst of a protracted recession, or possibly the first actual depression since the 1930's. In economic hard times throughout American history, voters have without exception, "tossed the bums out," and handed power over to the out of power political party. This means only one thing - President Hillary Rodham Clinton. Senator Clinton's main problem is that she has no core values except for one - she truly, honestly, deep down in her soul believes that government is a force for good in the world and should be used to solve problems. Everything else is subject to negotiation or whatever the latest poll says would be popular. This means that she will not hesitate to dust off the Franklin Delano Roosevelt playbook, and try to throw money and alphabet soup government programs at the nation's problems.

Unfortunately, FDR took office in an entirely different situation in which America as a country had not run up the largest debt in the history of the universe, and individual Americans had not run up the largest collective national credit card and home equity loan debt load in history (in the 1920's and 1930's, if you wanted to buy a home, you had to have something called a "down payment"). Since there will thus be no money available for President Clinton's desired programs, the only option will be to print more - lots and lots more - which will destroy what is left of the value of the dollar, and relegate the last vestiges of America's empire to the scrap heap.

Master Yoda remarked to Obi Wan Kenobi at the end of Empire that "there is another," when all looked hopeless. He was referring, of course, to Princess Leia. Unfortunately, that was a movie, and this is real life. Of all the declared candidates for President, only one is talking about taking the necessary hard steps to restore the value of the dollar and preserve the current American standard of living - Ron Paul - and he does not currently appear to have sufficient name recognition to be able to win it all. I predict, however, that he will show surprising strength that will force the mainstream media to finally pay attention to him as the campaign wears on and the economy worsens.

Normally, I am not an advocate of voting for fringe candidates you agree with who don't have a chance to win on the grounds that you are thereby not only wasting your vote, but actually taking a vote away from the candidate of the two major parties who you dislike least. I am going to make an exception this time because, as mentioned before, America is facing its most serious existential crisis since the Civil War and not one other candidate is addressing the seeds of our coming financial implosion at all. Paul, on the other hand, is speaking directly and clearly about what needs to be done - pull our troops back from their outposts scattered all over the world that we can no longer afford, drastically slash federal taxes, spending, and regulation, and put our currency back on a modified gold standard so it has actual value. The rest of the world is in the process of taking away our national credit cards so there are no other choices available.

Many criticize Paul for his plans to withdraw from Iraq, just as it is becoming clear that our brave soldiers are finally winning the fight against the insurgency (the main indicator that we are winning the battle on the ground is that Iraq reports are vanishing from mainstream media news outlets). The way we achieved victory was to throw more resources and troops at the problem. Unfortunately, $1.8 trillion dollars into the problem, there is no more money to expend on being the policeman for Iraq, or any other country for that matter. Once the troops draw back down to their pre-surge levels, it will be up to the Iraqis to govern themselves - and they don't have a good track record on that score. Try to guess who said the following quotes:

...We rushed into the business with our usual disregard for a comprehensive political scheme. We treated Mesop[otamia] as if it were an isolated unit, instead of which it is part of Arabia.... When people talk of our muddling through it throws me into a passion. Muddle through! why yes, so we do—wading through blood and tears that need never have been shed.

...We are largely suffering from circumstances over which we couldn't have had any control. The wild drive of discontented nationalism...and of discontented Islam...might have proved too much for us however far-seeing we had been; but that doesn't excuse us for having been blind.

No, it wasn't Barrack "Audacity of Hope" Obama (what is supposed to be so audacious about hope anyway?); it was Gertrude Bell, an administrator of the British Mandate in Iraq in the 1920's, which ended about the same way as our try at civilizing Iraq will end soon. Some things never change.

Read all about Congressman Paul's economic ideas in the best of his books. Go, Ron, GO!

The Great Unwinding

I hope everyone loaded up on some gold during the recent buying opportunity mentioned two posts ago. Gold is now headed straight back up again as the dollar continues its freefall. The ongoing appreciation in the Chinese yuan often discussed in this blog also accelerated this week. But today I would like to highlight another great investment opportunity for the immediate future - the unwinding of the yen carry trade and how you can profit from it.

The yen rose against every single one of the world's 16 major traded currencies this week, primarily due to the unwinding of the yen carry trade. What is this "carry trade," and why is its unwinding such a big deal?

Following the collapse of Japanese stock market and real estate bubbles in the early-1990's, Japan's economy sank into a depression that lasted until 2004. The current economic recovery is still tentative, but slowly gaining steam as Japanese trade with China increases by leaps and bounds. During the depression, the Bank of Japan cut interest rates drastically in an attempt to stimulate the economy, and Japan's overnight bank rate of 0.5 percent is now far and away the lowest in the industrialized world. A middle class Japanese worker with a good credit rating can get a housing mortgage loan for 2.75%.

The carry trade developed as a result of the disparity between Japanese interest rates and those of foreign countries such as New Zealand, which awards 8% interest on their government bonds. Literally millions of Japanese housewives in search of greater returns on their savings have marched down to their neighborhood bank and moved their savings into foreign currency accounts denominated in New Zealand dollars, Australian dollars, Canadian dollars, Swiss Francs, and even US dollars, and paying much higher interest rates than a passbook saving account denominated in yen. Foreign hedge funds, investment banks, and even wealthy private investors have gotten into the game as well, borrowing literally billions of dollars at very low interest rates and then investing it overseas in much riskier investments.

This carry trade only works as long as the yen stays relatively stable or decreases in value in relation to other foreign currencies. Japanese housewives know that an increase in the value of the yen by just a few percentage points can wipe out their gains in interest very quickly, so they monitor the exchange rates between the yen and their chosen currency fairly closely. Since Japanese investors tend to move as a group, once the carry trade starts to unwind, that unwinding can accelerate pretty quickly.

The unwinding mechanism works like this: The level of risk begins to increase in the market due to a stock market drawdown somewhere in the world. Foreign currencies accordingly start to fluctuate in value more than usual. That fluctuation in currencies causes some carry trade investors to get nervous and unwind their positions. To do this, they sell their foreign stocks or bonds or withdraw money from their foreign currency denominated savings accounts. Then they transfer that money back to their Japanese bank account. This involves converting their foreign currency back to yen, which causes the demand for (and therefore the value of) the yen to increase, and the value of the currency they are selling to decrease an equal and opposite amount. This rise in the yen's value then causes more investors to unwind their carry trade positions, and a vicious cycle is underway.

How bad can it get? During the market turmoil caused by the Russian government defaulting on its sovereign debt in 1998, the yen soared in value by more than 20% in less than a month, as investors fled from riskier investments. The markets quickly adjusted to that crisis and were rising again smartly just a few months later. This time will be quite different. What is happening now is a massive credit crunch like the late-1980's Savings and Loan crisis, only much worse this time due to the huge numbers of adjustable-rate mortgages that will be resetting throughout the next year, and the literally trillions of dollars of credit derivatives that are based on those loans. The value of the dollar is also dropping like a stone as it slowly but surely loses its status as the world's reserve currency, as discussed in more detail in previous posts.

These two inter-related factors have foreign investors fleeing for the exits, which has precipitated the beginning of the next great carry trade unwind. The yen has gone from above 124 to below 108 so far this year, and is accelerating upward. For the reasons discussed above, this will continue on and off depending on short-term market conditions until the yen finally settles out at at least 80 yen to the dollar and quite possibly beyond that.

What's the best way to play this? All the normal choices discussed in previous posts on the yuan and gold are available. The simplest and safest way would be to convert dollars to yen at a bank, but the interest rates on your yen deposits would be very low, and of course there would be no interest at all if you held your yen in a safe deposit box or in a safe under your bed (don't laugh too quickly - one of the best-selling consumer items in Japan throughout the early-2000's was small household safes). As the number of bank failures in the US starts to increase soon, don't be surprised to see safes gain in popularity. As mentioned in a previous post, your best bet if you go the foreign currency savings account route is Everbank.

Moving along the risk spectrum, the next method is investing in FXY, a currency Exchange Traded Fund (ETF) that matches moves in the yen-dollar rate almost penny by penny. FXY has options available, but only for about nine months into the future. If you choose to buy the options to gain leverage, buy the farthest out month (currently June 2008), and every three months sell those options and buy the new ones three months farther out (this is called "rolling over" or "rolling out" your options). A friend of mine who uses this method bought 23 March 2008 options contracts three months ago and just rolled them over to June 2008. He had a nice profit of $9,600 when he sold the March options. These are the best methods for people who only have a stock brokerage account and don't have futures trading ability yet. See previous posts for more details about ETF's and options on ETF's.

For real leverage, you can use futures contracts and options on those futures contracts. As you know from previous posts, I prefer the options on the futures contracts to the futures contracts themselves, since there is no question the yen will be higher against the dollar at this time next year, but there will likely be radical swings up and down between now and then. Using options instead of the actual futures contracts will keep you from getting stopped out or worse, getting margin calls, during those swings. I'm using the March 2008 9200 strike price options right now, although I don't recommend them for someone buying now as they have moved into the money recently, and out of the money options appreciate faster. Accordingly, I'm going to be rolling them into the June 2008 9500 strike price options soon.

To give you an idea of the effects of leverage, I bought those March options on October 19, 2007, and they are now up 215% each while the yen rate itself is only up about 6% since then. In previous posts I recommended Xpresstrade as the best online broker for do it yourself futures and futures options investing. As an update, at the end of this month, they will complete their merger with optionsXpress and cease to exist. At that point, I recommend switching to optionsXpress as a great one stop shop for all your investment needs. You will be able to trade stocks, bonds, mutual funds, stock options, futures, and futures options all in the same account in a user-friendly interface. I'm not aware of any other broker, online or offline, that offers that trading convenience at anywhere near optionsXpress' commission rates.

Just to round out the total picture, World Currency Options are also traded on the Philadelphia Stock Exchange. These were the original options on currencies, and were once the only way for the small investor to gain leverage on their currency investments. With the introduction of options on futures contracts, currency ETFs, and options on these ETF's, their days are probably numbered, but you can still use them as a way to gain leverage directly on the movements of an underlying currency.

Sunday, November 18, 2007

Options, Options, Options

The market action this week provided a great demonstration of why I mentioned in my last post that options on gold futures contracts were my favorite way to play the ongoing bull market in gold. As gold continues a profit-taking pullback prior to advancing to all-time highs, my margined gold futures contracts and FOREX gold and silver positions were all stopped out, preserving some of my profits, but also meaning that if the market had turned on a dime and shot back the other way, I would have missed out on some of the move up while I was still trying to decide where and when to get back into the market. Because the vast majority of my positions in silver and gold are in options on December 2008 futures contracts, those positions are temporarily down in value, but still in play to benefit from the inevitable turnaround.

This example shows in a nutshell why options are a great choice for investing in commodities that you are sure will move either much higher or much lower in the future, but can't be sure exactly when the big move or moves will occur. As discussed in previous posts, since you pay for an option in full up front, your loss is limited to your initial investment if it expires worthless, and that can only happen if you fail to roll it over prior to its expiration date. On the other hand, since futures contracts and FOREX positions are heavily margined, investors have to close them out quickly when the market starts moving against their positions, as happened to my margined positions this week. Futures and FOREX traders who do not do so quickly become former traders.

So why does anyone trade margined positions then? Why doesn't everyone just trade options? The answer is that since you pay the full value of the option at the time you establish a position, you can't control as large of a total position size as you could in the futures, since you only have to make a small "deposit" when you establish a position in a futures contract, as discussed in more detail in previous posts. Like everywhere else in the market, taking greater risk creates the possibility of greater returns.

Options on stocks and Exchange Traded Funds (ETF's) were discussed in detail in my November 8, 2007 post. The main difference between options on stocks and options on futures is that a futures option gives you the right to buy or sell one futures contract at a set price at a set future date, instead of 100 shares of an underlying stock. Other than that difference, the underlying concept is basically the same. A speculator looking for the maximum leverage would purchase a futures contract on a given commodity, and would consequently assume the risk of greater losses than his or her initial investment if their margined position moved against them far enough before they closed it out. A speculator looking for high leverage, but also looking to avoid margin calls, would instead purchase options on a futures contract.

Let's look specifically at some examples for each method. As of this writing, with gold trading at $787 per troy ounce, a speculator with $10,000 could choose to control two full size 100 troy ounce gold futures contracts (leaving a $1,900 cash cushion), or 10 e-mini 33.2 troy ounce gold futures contracts (leaving a $2,300 cash cushion). The speculator could also choose to buy two call options that would give him or her the right to purchase two full size 100 troy ounce gold futures contracts at a price of $800 per troy ounce on November 20, 2008 (leaving a $180 cash balance). If the price of gold moved from $787 to $887 per troy ounce sometime in that period and the speculator decided to take profits at that point, the respective profits would be $20,000 for the two full size contract choice, $33,200 for the 10 e-mini contract choice, and $12,700 for the two call options.

The $12,700 profit on the call options represents a gain of just under 160%, but was achieved without having to worry about margin calls or getting stopped out of the position at a loss. True to the concept of greater risk taking opening up the possibility of greater gains, the margined futures contract positions were up 247% and 431%, respectively, but if at any time following the opening of the position the price of gold had gone down by just $4 to $783, the futures contract holders would have received margin calls asking them to deposit more money, at which point most futures traders would have closed out their positions. There is also the ongoing mental stress associated with holding heavily margined positions to consider.

Options on futures should only be considered by a speculator who has a very firm view of the future direction of a particular commodities market, as options can expire worthless if they are not rolled over. So the obvious question at this point in time is whether or not gold is certain to move significantly higher in the next few years. Since nothing is certain in this world except for death and taxes, a better question is what it would take for gold NOT to move significantly higher. The only scenario that derails the ongoing gold bull market is one in which: (1) the Fed embarks on an aggresive campaign to raise interest rates to protect the dollar, thereby throwing millions more homeowners out on the street than are headed out on the street already; and (2) the politicians in Washington embark on an aggressive campaign to cut federal spending on defense, Social Security, Medicare, etc. enough to generate huge annual budget surpluses for at least the next generation. Each speculator or investor will have to make up their own mind as to whether or not they see the above scenario coming to fruition anytime soon.

Monday, November 12, 2007

Soaring Asian Currencies

Previous posts discussed in detail the ongoing appreciation of the yuan and described how to take advantage of it for financial gain. Hopefully you took some action, because last week the yuan had its largest weekly gain since it was allowed to float in a limited range against a basket of currencies in 2005. Not to be outdone, the Japanese yen also broke up and out of a trading range and cracked the 110 yen to the dollar level, as increased risk aversion among investors caused an unwinding of yen carry trades. Once we finish our ongoing series on how to play the bull market in gold, we will discuss why the yen should appreciate in value over the next few years, as well as the best ways to profit from that opportunity.

Today's topic is how to trade gold futures contracts. We have already discussed how to buy physical gold, gold-related Exchange Traded Funds (ETF's), and stock options on ETF's. The next level up the risk/reward ladder is gold futures contracts and options on those contracts. In a previous post on how to trade yuan futures, we discussed what a futures contract is in detail, and why yuan futures are still not robust enough to provide a good trading vehicle to play the ongoing appreciation in the yuan. Gold, on the other hand, has a variety of futures contracts that have high daily trading volumes, as well as options on those contracts.

If you are not clear about what a futures contract is, dig back into the archives and re-read the October 30, 2007 post on Trading Yuan Futures before reading further. The main gold futures contract trades on the New York Commodity Exchange (COMEX), and is for 100 troy ounces of gold. It has an initial margin of $4,050 and a maintenance margin of $3,000, which means you would have to have an uncommitted $4,050 in your trading account to use as your "deposit" to purchase one full size gold futures contract, and would have to maintain $3,000 in your account until you closed out your position.

For most investors, that's a very high initial margin, and because the contract is so large, the big price swings that come with even very small changes in the price of gold may be too much for the small investor to be able to handle and also sleep well at night. Luckily, there is another option, the e-Mini gold contract that trades at the Chicago Board of Trade.

The e-Mini gold contract is for 33.2 troy ounces of gold, and has an initial margin of $770 and a maintenance margin of $570. So for an initial deposit of $770, you can control a contract worth more than $26,000 of gold. The e-Mini contracts generally have lots of volume in the "forward month" (the one closest to expiration) and very little in the other months, so to get a good fill price, you should always try to buy the forward month contract.

At the time of this writing, December is the forward month. The trading symbol for the gold e-Mini contract is XK, and the symbol for the month of December is always "Z" no matter what commodity you are trading, so the symbol for the forward month December 2007 gold e-Mini contract is XKZ07. Since the forward month has heavy trading volume, it is safe to use market orders to enter and exit your trade. If you trade online, you just have to enter the symbol and place a market order good for the day. If you trade through a human broker, you would just tell them you want to "buy one XKZ07 contract at the market good for the day."

As mentioned in the previous post about yuan futures, the advantage of directly trading futures contracts is that you maximize leverage, and the disadvantage is that because you are using so much leverage, even small changes in the price of the underlying commodity can cause big swings in the value of your position, and you will be held liable for losses that exceed your initial deposit. In the next post, we will discuss my personal favorite way to play the current gold bull market, options on gold futures contracts. With options, you still enjoy high leverage, but your risk is limited to your initial investment. You will never get a "margin call" asking you to put more money into your account to cover large swings in price that temporarily move against you.

If you haven't gotten onboard the gold bull market yet, it's not too late. As a matter of fact, there is an ongoing pullback in gold that will provide better entry points to establish or add to gold positions than you would have enjoyed as recently as last week.

Thursday, November 8, 2007

Options and Okinawa

Before we get into discussing options, I would like to publicly announce that my daughter and her partner came in second place in the mixed doubles competition of the season-ending Far East High School Tennis Tournament, and following the tournament she was named to the All Far East team. In the championship match against a team from Seoul American High School, she and her partner won the first set 6-2, but then unfortunately dropped the next two sets. Congratulations!

My daughter's championship match was very similar to the attempt by the world's central banks to hold down the price of gold earlier this week when it was approaching the psychologically important $800 mark. The central banks, in cahoots with large commercial speculators who hold large short positions in gold, were able to hold the gold price down below $800 for about a day, but ran out of ammunition on the second day and were completely overwhelmed as gold soared to close to a price of $850 per ounce within 48 hours of breaking past the wall of resistance at the $800 mark. Expect something similar to happen around $850 and $900 as well.

In the last post, we discussed ways to buy Exchange Traded Funds (ETF's) that would profit from the rise in gold. Today we will discuss how to juice up the returns from ETF's using the leverage of stock options. An option is just what it sounds like - it is a contract that gives you the "option" of purchasing 100 shares of the ETF or stock in question at a set price on a set date in the future. The set price is referred to as the "strike price," and the set date is referred to as the "expiration date." Options that are purchased to bet on a rise in the price of the stock are referred to as "call" options, and options that are purchased to bet on a fall in the price of a stock are referred to as "put" options.

For example, the best option to purchase if you believe that GDX, an ETF composed of a wide variety of unhedged gold mining companies, will be going up in value would be the January 2010 $60 strike price call option. That sounds complicated, but it is not hard to figure out if you translate it word by word. This option gives you the right to purchase 100 shares of GDX at a price of $60 per share on a set date in January 2010.

Let's say you purchase such an option, and a year later want to get out of the position. If GDX stock is trading for $60 per share on that date, you could "exercise" your option by purchasing 100 shares of GDX at $60 per share, and then turn right around and sell the stock back into the market at the current price of $60 per share. No speculator in their right mind would ever do that at that price because the purchase and sale would cancel each other out, and they would lose money due to the transaction costs (brokerage commissions) involved in executing those trades. For the same reasons, you would not want to exercise the option if GDX stock was trading below $60 per share, since you would lose money if you bought 100 shares at $60 each and then sold them at the lower current market price. That is why the majority of options expire worthless and are never exercised.

That brings us to the profitable case - when GDX shares are trading above the strike price of the option when you exercise it. For example, if GDX shares are trading at $70 per share, you can exercise your option and buy 100 shares at $60 each for a total cost to you of $6,000. You can then turn right around and immediately sell those shares in the open market for $70 per share (the current market price) for a total of $7,000, giving you a quick $1,000 profit.

So how does the potential profit from buying options compare to the potential profit from just buying regular shares in an ETF or stock? Let's look at an example.

If an investor purchased $10,000 of GDX shares at $50 per share in 2007 and then sold them when the price of GDX stock increased to $60 per share in 2008, he would make a profit of $2,000 (excluding transaction costs). But if the same investor instead purchased $10,000 of GDX call options when GDX was trading at $50 per share, and then sold or exercised them when the price of the common stock increased to $60 per share, he would have a profit of approximately $10,000 instead, a result five times better than just buying shares of the common stock. This is the power of leverage in action.

So what's the downside - why doesn't everybody just buy options instead of stocks?

There are two reasons. First, stocks do not have expiration dates. If a stock moves against you, you could hold it for literally years waiting for it to come back to your break even point. If you hold an option to its expiration date and it expires at or below its strike price, it expires worthless and you lose your entire purchase price. Most investors do not realize that there are two simple solutions to this dilemma - either sell the option to another investor in the market if its value falls to your mental stop loss position (that way you only lose as much of your investment as you decide prior to the trade you are willing to risk on that one position), or "roll" the option. Rolling over an option means that you sell an option that is about to expire while there is still some profit that can be extracted from it, and then immediately turn around and purchase an option at the same strike price that expires at a later date. In this manner, you never have to reach an expiration date unless you want to.

The second reason most investors purchase stocks instead of options is that they are unfamiliar with options and if they know about them at all consider them to be too exotic and risky for normal investors to trade. As discussed in the preceding paragraph, there are loss mitigation strategies that can make trading options no more risky than trading common stocks - and options have far more profit potential than shares of common stock.

In the last post, we talked about two ETF's to play the ongoing appreciation of the gold price - GLD and GDX. GLD unfortunately does not have any listed options, so you have to purchase common shares. But GDX does offer options, and as mentioned previously, if you'd like to dip your toe in the water and experience the superior profit potential that comes from trading options, your best bet is most likely the January 2010 $60 call option. This option has lots of time left on it until it expires, and I can think of no scenario in which the price of gold will not be significantly higher at sometime in the next two years.

If you have never traded options before, getting started is easy. Most brokers just ask you to fill out a form and mail it in to them and then they give you permission to trade options. Some online brokers will even allow you to apply online and save the cost of the envelope and stamp if you already have a brokerage account with them. Good luck!

Wednesday, November 7, 2007

The Demise of the Dollar

The last few posts have discussed the ongoing bull market in gold. That bull market picked up steam in a big way in the overnight markets in Asia, with gold rising from $824 to $845 dollars per ounce. My FOREX positions in gold and silver more than doubled again today. The cause of this tremendous rise in the precious metals was simple - the dollar fell off a cliff all last night, losing ground steadily with hardly a pause against all of the 16 major currencies, including the yen. This of course led buyers to rush to the precious metals, the traditional store of value during inflationary times.

The cause of the dollar's slide was simple: Taking their cue from supermodel Gisele Bundchen, China announced they would diversify out of their dollar holdings into "stronger currencies." Since China currently holds several trillion dollars of the US national debt, this is not good news for our country. Lenin once remarked that, "The last remaining capitalist will sell you the rope you need to hang him." This is precisely what our government has done with its profligate spending and reckless rush into unprecedented indebtedness - an indebtedness that is primarily owed to Japan and China. Sun Tzu said several thousand years ago that, "The best general wins without having to fire a shot." By selling China the rope they needed to hang us, there is no need for a geopolitical or military confrontation with us; they merely need to sell their enormous stash of dollars into the open market. They have now announced that they have begun that process, leading directly to today's drastic increase in the speed of our dollar's inevitable descent into worthlessness. Hence the huge rally that is continuing even now in the precious metals.

In yesterday's post we talked about how to buy physical gold. Today we will discuss the next most conservative way to invest in the gold bull market - Exchange Traded Funds (ETF's). An ETF is very similar to a mutual fund, except that it trades on a major stock exchange so that you can buy and sell shares of it through your broker, just like shares of common stock. To invest directly in gold itself, just buy shares of the ETF with the stock symbol GLD. The fund's managers place more gold in a vault in London every time people buy more shares of GLD, and the fund's value moves almost in lockstep with the movements of the spot price for gold. Since the gold is held in London, it should be safe from confiscation by President Clinton a few years from now, but there are a few conspiracy theorists on the Internet who have meticulously examined the fund's prospectus and who have their doubts. In general, though, this is a safe and easy way to share 1 for 1 in the rise in the gold price without having to deal with the inconveniences of holding and storing physical gold.

In past gold bull markets in history, there is a discernable pattern. First gold rises, then the shares of leading gold mining companies go up even more than gold, and finally, tiny junior explorer gold companies soar in value the most of all. We are at the point in this bull market when the leading gold companies are just starting to make their move to catch up with the increasing price of gold itself. To avoid single company risk, the best ETF to play the rise in the stock prices of gold companies has the stock symbol GDX. The companies in this ETF are unhedged, which means they benefit the most from a rise in the price of gold. Some gold companies are hedged, which means they have entered contracts in which they agreed to sell some of their future gold production at lower prices than gold is currently trading. Of course, you want to avoid investing in these companies. Therefore, GDX provides a way to make one stock trade that gives you shares in a large group of unhedged companies, including both leading companies and junior explorers. GDX will soar in value during the next phase of gold's bull run.

In tomorrow's post, we will discuss the riskier process of how to buy stock options on gold ETF's to get more leverage. If you are not comfortable trading options and desire to use the ETF method discussed here today, a good way to do so would be to purchase equal dollar amounts of both GLD and GDX.

Tuesday, November 6, 2007

The Golden Bull

I don't know what it is about my posts lately, but the day after I posted recently that the Chinese yuan would be increasing in value, it made it's largest gain since it was allowed to float a small amount against a basket of currencies. Then in yesterday's post, I made the case for the coming bull market in gold. Sure enough, gold then shot up today to $824 per ounce as of the time this post is being written.

It's also interesting that after writing a post a few days ago that was fairly critical of FOREX trading, my FOREX trading account (which is equally divided among gold, silver and Canadian dollar positions) was up by more than 125% just today. I quickly moved up all my stops since what 50:1 leverage gives, 50:1 leverage frequently takes right back!

So what is the best way to play the bull market in gold? I'll save my opinion on that subject for a future post. Today, as promised, we will start by taking a look at the most conservative way to invest in gold - buying physical gold. Then in future posts, we will discuss progressively riskier (and potentially more rewarding) methods of investing in gold.

The easiest way to buy physical gold is at a reputable coin shop or dealer. Some people like to purchase rare coins that are made of gold in an attempt to increase the return on their investment, but for most people it is better to just purchase one ounce national gold bullion coins, unless you are a coin collector or hobbyist who really knows what you are doing. The most popular such coins are the South African Krugerrand, Canadian Maple Leaf, American Gold Eagle, and Australian Nugget. These coins are very portable, easily hidden, and instantly recognized as a store of value worldwide. Of the three, the Krugerrand is your best bet because it has the lowest dealer markup for obscure reasons that date back to apartheid days. If there is no coin shop or dealer in your area, it is possible to order gold coins online as well, although if you choose to go that route, be sure to thoroughly check out any prospective sites before you send them any payment.

As mentioned in yesterday's post, for American citizens, you might want to go a different route in case President Clinton at some point takes away the right of American citizens to own gold again. If this possibility concerns you, I recommend a unique entity known as the Perth Mint, which is run by the Government of Western Australia. They run the only government-operated gold and silver bullion certificate program in the world. You can purchase any amount of gold that you desire through their website. You receive a certificate in the mail, and they store the gold in their vaults in one of the safest and most politically and economically stable countries in the world. For an extra annual fee, you can choose segregated, allocated storage under your name. Otherwise your gold and silver is stored together with everyone else's.

Tomorrow we will take a look at how to invest in a gold Exchange Traded Fund (ETF).

Monday, November 5, 2007

The New Gold Rush

Gold closed above $800 per ounce on Friday for the first time in more than 27 years. It's now just a short distance to gold's all time nominal high of $850 per ounce that was reached in January 1980. In inflation-adjusted terms, though, gold is still well below its all time high of more than $2,200, so it still has plenty of room to run - and run it will.

The conditions that led to gold's last monster run were stagflation and a plunging dollar, coupled with all-time high oil prices due to a tense standoff between America and Iran. Sound familiar? I was in high school then, and I remember very clearly that at the peak of gold's run there were stores in every shopping mall selling gold coins, television commercials extolling the merits of investing in precious metals, and investing in gold was a popular conversation topic at parties, much as Internet stocks were in 1999. My father told me recently that he bought some one ounce South African Krugerrand coins in 1979 that are just now becoming worth more than what he paid for them again. Until we see this type of activity again, it will still be safe to buy more gold.

Gold is traditionally bought as a hedge against inflation. When governments print excessive amounts of paper money, each existing dollar becomes worth less than it was the day before the new paper money was printed and added to the money supply. Governments worldwide are currently printing new batches of paper money like it's going out of style in a desperate but futile attempt to bail out the big banks which are sitting on large piles of now worthless securities that were backed by pools of subprime mortgage loans that are being foreclosed on right and left as Adjustable Rate Mortgages reset beyond the ability of cash-strapped homeowners to pay. Last Thursday alone, the Federal Reserve pumped an additional $41 billion new dollars into the world monetary system.

It's simple supply and demand - as the value of each dollar becomes less, the amount of stuff you can buy with it goes down. The result - rising prices of everything from bread to automobiles to gasoline to heating oil. Throughout human history, at such times people have turned to gold as a store of value to protect them against the drop in value of their rapidly becoming worthless paper money.

This is a worldwide phenomenon, but is particularly acute for the United States, since unlike in the late-1970s, we now have the largest accumulated debt of any kind in the history of the universe, more than $9 trillion and growing ever larger as you read this. There is no possible way the United States can ever pay this debt back in full. Just servicing the interest on this mountain of debt will cost American taxpayers more than $400 billion dollars in the next fiscal year.

There is only one way out of this mess - to deflate the value of the dollar so we can pay back the nations (primarily Japan and China) that lent us this money with dollars that are worth much less than the ones they originally lent us. This is the exact strategy that was used by the Weimar Republic in Germany in the 1930's. They could not afford to repay the excessive war reparations that were thrust upon them by England and France at the end of World War I, so they devalued their currency and paid the reparations back with worthless money. At the height of the ensuing hyperinflation, people were actually burning stacks of German money in their furnaces to keep warm because firewood was more valuable than the paper money - and everyone has heard the stories about needing a wheelbarrow full of money to buy a loaf of bread then.

So why hasn't this happened in America yet, when our national debt has been off the historical scale for quite some time now? The answer is simple. For the last 75 years or so, the other nations of the world have allowed the dollar to function as the world's reserve currency, and therefore helped to prop it up. Oil, gold, wheat, etc. are all priced in dollars. That is now changing. Many nations, including China and Kuwait, have dropped their currency pegs to the dollar. Iran will no longer accept dollars as payment for their oil. There are reports that at OPEC's next meeting they will vote to no longer price oil in dollars, but rather against a basket of other currencies. Most tellingly, there is this story.

History tells us what happens when a nation's currency ceases to act as a reserve currency. When the British pound was replaced by the dollar as the world's reserve currency, it lost more than 70% of its value. In this inflationary environment, gold will do what it has always done throughout human history in similar situations - soar in value. Fair warning, though - the governments of the world will do their best to hold gold down in a vain attempt to preserve the values of their paper currencies. They will lose, but they will put up a heck of a fight. Before this is all over, we will see gold moving up and down as much as a $100 per ounce in a single day. And don't be too surprised if President Clinton takes away the right of Americans to own gold around 2010 or so to protect the dollar, just like President Franklin Roosevelt did. So fasten your seat belts and climb onboard the gold train now!

The next few posts will detail the best ways to play the rise in gold, starting with the most conservative methods, and working up to the high risk-high reward strategies.