Diversification is one of the most important things to get right when managing a portfolio, because when done properly, it can increase the rate of return you can expect from a given amount of total risk, or decrease the risk required to achieve a given rate of return.
When some assets are rising in price, usually other ones are declining, which creates opportunities to cycle capital into those undervalued assets.
And in my opinion, having exposure to precious metals is a useful part of diversification, because they are partially uncorrelated with stocks and bonds and have different and unique risks and opportunities.
The key problem with investing in gold and silver, however, is that they don’t produce cash flows. They just sit there, and an investor hopes to eventually sell what they bought at a higher price than he or she originally paid for it.
But, you can actually get paid to own gold and silver. I keep about 5% of my portfolio in precious metals, and generate a substantial amount of investment income from it.
This article provides extensive info on how to invest in gold and silver in such a way that it can produce a substantial income, so that you don’t necessarily have to rely on capital gains or try to predict price movements in these metals.
And it will discuss the downsides of this approach as well.
Start reading the whole article from here, or jump to the section you want:
- 2 Key Problems with Precious Metals Investing
- How to Generate Income from Precious Metals
- An Example with Silver
- How to Value Gold
- How to Value Silver
- Warren Buffett’s Silver Investment
- Why Miners are Risky
2 Key Problems with Precious Metals Investing
Investing in gold, silver, or any commodity is filled with headwinds against you.
Firstly, commodities, including precious metals, don’t produce any cash flows like a profitable business or even an interest-paying bond does. Instead, they just sit there, as you hope they go up in price. Precious metals are good at holding their value over the long-term against inflation, but apart from that, don’t do a lot for you by themselves.
Warren Buffett perhaps said it the best:
The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you….it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.
Secondly, there are transactional costs associated with precious metals investing. If you buy physical gold, there’s a company in the middle making a profit. They buy it at wholesale prices, turn it into fine investment-grade gold, and sell it at retail prices. There are potentially shipping costs, and there is a cost associated with security and storage, along with a risk of theft or loss. If you instead invest in an ETF that holds precious metals, they have an expense ratio, which covers security and all the administrative costs of managing the fund and their hoard of metal.
So, not only does typical precious metal investing not produce cash flows and instead relies entirely on the metal appreciating in price, investors start at a loss due to the associated expenses along the way.
There can certainly be a place for physical precious metals in your net worth. Some investors use it as a hedge against catastrophic risk, like the collapse of a national economy. But overall, there are substantial downsides.
That’s why I take a different approach, and instead use silver and gold as an income-generating investment in my portfolio. It improves diversification while paying for itself.
How to Generate Income from Precious Metals
Here’s the short version:
- Identify an ETF that holds your desired metal, such as the iShares Silver Trust (SLV) or the SPDR Gold Trust (GLD), that also has an options market.
- Sell cash-secured put options for shares of that ETF at a strike price that is below the current market price.
- If the put options expire without being exercised, keep the profits from the option premiums and sell the puts again.
- If the put options are exercised and you now own shares of the ETF, sell covered call options at a higher strike price than what you paid for the shares, and above the current market price.
- Continue selling covered calls, until eventually the options are exercised and the shares are sold.
- Start over, and sell cash-secured put options at a strike price below the current market price again.
I refer to it as option-weaving. You weave in and out of the same shares by selling puts and calls, collecting option premiums at each step. This strategy naturally results in repeatedly buying fairly low, and selling fairly high, and collecting option income along the way.
When you sell an option on a stock or an ETF, you’re selling someone the right, but not the obligation, to buy or sell the shares from/to you (depending on whether it’s a call or a put) at a certain price within a certain time frame. And in exchange for that, the option buyer is giving you a cash premium up front. If you’re not familiar with this, check out my guides:
A Detailed Example with Silver
Now for the long version, with an example.
Let’s say shares of the iShares Silver Trust (SLV) are currently trading for $15 each, and the underlying price of silver is currently $16/ounce. ETFs like this one correlate in price very strongly with their underlying metal, with the exception being that there is a small expense ratio, which is 0.50% per year in this case.
The historical inflation-adjusted price of silver looks like this:
So, $16/ounce is a decent price compared to historical norms. It could go cheaper, but it’s also far lower than it was during times it was in a bubble. So, overall, it’s reasonably priced, and inflation helps drive up the actual price over time on top of this volatility.
Now, we’ll sell cash-secured put options for a strike price of $14.50 that expire 3 months from now, and we’ll receive let’s say $0.40/share in premiums up front. The premium size will depend on how volatile metal prices currently are. Each option contract is for 100 shares, and you can do many contracts or just a few contracts, depending on how big your portfolio is and how large or small of a position you want. Let’s assume for this example we do it with 10 contracts, so we put $14,500 in cash up front, receive $400 in option premiums up front, and are now potentially obligated to buy at a price of $14.50 any time within the next 3 months.
Suppose that the price of SLV rises to $15.30 over the next three months, and our options expire without being exercised. We earned a nice 2.8% rate of return in 3 months, which equates to 11.8% annualized. We can now sell new puts. Maybe in this case since the price of silver increased a bit, we will sell 3-month puts at a strike price of $15, and receive $0.50 in premiums per share. So, we set aside $15,000, and receive $500 up front.
Let’s say, again, that those options expire, because SLV dropped to $15.20 but stayed over our strike price of $15. We can now sell options again, and let’s say we sell the options at a strike price of $14.50 again, with a $0.30 premium this time since it’s fairly far out of the money. So, we put $14,500 aside, and collect $300 up front.
This time, SLV share prices drop to $13.80, because for whatever reason, the price of silver declined. So, we’re obligated to buy the shares of SLV at $14.50 each, and we still got to keep all of those option premiums we earned along the way. We’re now proud owners of 1,000 shares of the iShares Silver Trust, along with $1,200 in cash option premiums we received for our three rounds of option sales.
So, at this stage, we sell covered calls at a strike price of perhaps $16. Because that’s a pretty big distance from the current price of $13.80, we might have to sell longer-term contracts to get worthwhile premiums. Let’s say we sell 6-month covered call options at a strike price of $16, and receive $0.40 in option premiums. Therefore, we receive $400.
SLV goes up to $14.92 within the next 6 months, so our covered calls expire. All of those covered call premiums were basically just like a big fat dividend on our shares of silver. We now sell 6-month calls at a strike price of $16 again, and get $0.50 per share in option premiums up front, or $500.
SLV goes up to $15.43 within the next 6 months, so once again, our covered calls expire, with the result being another big fat dividend. We now sell 3-month calls at a strike of $16 for $.35 each, and thus receive $350 in premiums.
This time, SLV shoots up to $16.75/share, but due to our covered call, we have to sell at $16.
Here’s the summary of what happened over those 24 months:
- We bought 1,000 SLV shares for $14.50 each, at the 9-month mark.
- We sold those 1,000 SLV shares for $16 each, thus making $1,500 in capital gains, at the 24-month mark.
- We collected a total of $2,450 in option premiums at various times over those two years.
Not bad. Especially because, this is just a part of our portfolio, and most of our money is in equities and other investments.
Assuming our broker charges $6/trade, we paid about $36 in trading fees. We’ll have to pay taxes on our gains, unless this is happening inside of a retirement account.
Also, it took a negligible amount of time. We only had to sell options every 3-6 months or so, which only takes a few minutes each time. A little longer if you do some extra research.
Now, since silver is still reasonably priced, we go ahead and start the process over again, and sell cash-secured puts for a strike price of perhaps $15.50/share. Rinse and repeat. Buy low, sell high, and get paid along the way.
The length of options you choose will depend on a few factors. I usually do 3-month options for my puts. I’ll keep repeating that process and collecting premiums until I own the shares. At that point, depending on how big the difference is between the current market price and a strike price that I’d be happy with (one that is above the price I paid), I might be able to sell 3-month covered calls, or I might have to sell 6-month or even 12-month covered calls. The bigger the difference between the market price and the target strike price, the longer you may need to go out with those calls in order for the premium to be worthwhile.
The important thing is that at no point in this process did we really care what the price of silver did. Whether it went up or went down, we just collected the premiums and bought or sold the shares accordingly. We’re not trying to accurately speculate what silver will do. We’re willing to get paid to wait to buy it at a lower price (by selling cash-secured puts), and then hold onto it and get paid with covered calls for as long as it takes to sell at a higher price. We’ll hold onto it for years if we have to, continually selling covered calls and getting paid. And if we eventually sell the shares, we’ll start over by selling puts again.
The key risk is that if you do this when shares of SLV are unusually high, the price of silver may fall to such an extent that you won’t be able to sell at a higher price any time in the foreseeable future, and you won’t even be able to sell long-term covered calls at a strike price higher than what you paid for them. That’s the only real mistake to avoid- don’t buy vastly overpriced shares of SLV.
Valuing metals can be tricky, but the main things are:
- Don’t obligate yourself to buy when it’s clearly expensive compared to its historical norms, like it was in 2011.
- Look at the current industry averages of how much it costs to mine it out of the ground, and use that as a reference.
- It doesn’t have to be super-low; it just has to be “reasonably” priced.
A later section in this article will discuss gold and silver valuation in more detail.
Downsides for this Strategy
There’s no free lunch, and no perfect investment strategy. This strategy, like all investments, comes with downsides and risks, which can be managed.
The first downside is that it is fairly advanced, in the sense that it requires the use of options. As far as options go, it’s a fairly straightforward and newbie-friendly type of strategy, but it’s still an active approach using options, which is above what many people feel comfortable with. This would be considered a conservative options strategy, but nonetheless, options can get very messy very quickly if you’re not deeply familiar with how they work.
The second downside is that it requires patience, is very long-term focused, and cannot produce outstanding short-term gains. In fact, the options put a cap on how high a rate of return you can get. A speculator who buys silver at $10/ounce and sells it at $30/ounce one year later may triple her money in a short period of time, but that’s a very unpredictable result, and investors will likely get it wrong as often as they get it right. This option-weaving approach, instead, limits you to a certain rate of return (perhaps 10-15%, depending on how high the option premiums are at the time), but is a reliable long-term source of income and diversification. It’s inherently for income and diversification, rather than speculative gains, and should only be employed for a portion of your portfolio.
The third downside is that unexercised option premiums are taxed at a high rate of short term capital gains taxes. So, it’s not a very tax-efficient strategy, unless you end up holding the silver or gold ETFs for over a year. Therefore, it’s best used inside of a Roth IRA or other retirement account. That being said, it can still be used in a normal taxable account, but taxes will take some of the profits.
(Related reading: Roth IRAs: How to Optimize Yours)
The fourth downside is that it does not protect against catastrophic loss. Investors that buy physical gold and silver and store it in their homes often do so because they fear the idea of a total economic collapse, and want to be prepared with a commodity that has been viewed as a currency worldwide for thousands of years. Many would argue that, in the event of such a crisis, paper-based ETFs that hold the metal far from you would be unreliable. Gold in particular is a good hedge against recessions, as both physical gold and gold ETFs usually rise in price during recessions, but only physical metals would be 100% reliable in the case of disaster. Therefore, again, this strategy using silver and gold ETFs is useful for income and diversification, rather than as catastrophe insurance.
The fifth downside, as I mentioned, is that you have to be careful not to obligate yourself to buy during times of unusually high gold or silver prices. Only use this strategy when the prices are reasonable compared to their inflation-adjusted historical norms.
Gold Investing 101- Uses and Valuation
Gold has been used as a currency in many places of the world for thousands of years.
Unlike most metals, it is resistant to oxidation and corrosion, which allows it to preserve its value for millennia. It’s extremely malleable, very good at conducting electricity, and it’s pretty.
About 85-90% of gold production finds its way into jewelry and bullion, and only 10-15% finds its way into industrial and technological use. This makes it inherently more like a currency than a commodity- its use does not really decline during recessions, and instead tends to increase in price during those times as fear and uncertainty are on the rise.
Still, a small portion of gold is used for a wide variety of practical uses. For example, as an electronics engineer I’ve used gold contacts for high-performance cables and I/O systems, due to the combination of high conductivity and strong resistance to corrosion.
The debate on what exactly moves the price of gold, or how to value it, is a philosophical and economic point of difference between experts with no foolproof answer.
Its price at any given time is determined partly by public emotion (economic fear or confidence), partly from real interest rates (since cash that earns actual interest returns in a bank may be more desirable than holding gold that produces no cash flow), partly from inflation or perceived future inflation (against which gold holds its value very well), partly from energy costs and other costs associated with mining it out of the ground (which can affect supply and demand), etc.
Here’s a chart of the year-end annual price of gold since 1970:
For most of US history since its founding, an ounce of gold was worth about $20, because money was defined by a quantity of gold. This spiked higher during the civil war, but was defined back down not long after. In the post-Depression 1930’s, gold was redefined at about $35 per ounce.
Eventually in the 1970’s, gold was decoupled from US currency, and so it has inflated in its face dollar value ever since. The highest price ever recorded was mid-2011 when it touched over $1,900/ounce during a gold bubble.
So, is there any way to value gold in a fundamental sense?
All-in sustaining costs (AISC) of gold mining companies measure the partial costs of various gold miners to produce gold, and is reported per ounce. If the price of gold per ounce dips too close to these values, or goes below them, gold miners become unprofitable. Realistically they become unprofitable above that level, but this is an industry-defined number. AISC is a metric published by the World Gold Council and reported by various gold mining companies, meant to help standardize reporting about mining operations. It is now applied to other metals as well.
Top miners currently have AISC at under $1,000/ounce, with the lowest ones under $800/ounce or as low as $600/ounce for specific massive mines. That’s how much money it takes to produce an ounce of gold. If the gold price drops to that, gold miners don’t make money because it costs them more money to produce the gold than they get for selling it.
Different mines around the world have very different operating costs. Much of the gold in North America is accessible, and therefore cheaper to mine. In contrast, much of the gold in Africa is deep, and therefore expensive to mine. In addition, the AISC includes the costs of exploration and administrative office overhead and other expenses that, if necessary, can be reduced temporarily for a gold miner to survive a period of low gold prices. In the end, it can be roughly said that the cost of mining gold varies in a spectrum between $600 to $1,200 an ounce these days depending on the mine and depending on which costs are being included in the calculation.
The amount of money it takes to mine an ounce of gold has increased dramatically over the last decade. Energy and labor prices have affected the cost significantly. Exploring for new deposits in difficult locations, securing permits amidst legitimate fears of environmental damage, and setting up mining infrastructure is a long and expensive process. And as the easier gold locations get mined out, the ones that are left are harder and more expensive.
And then on top of that, the free cash flow (FCF) breakeven point tends to be about 50% higher than the AISC per ounce. So, if a company reports AISC of $750/ounce, it would typically need gold to be at about $1,050/ounce to report positive free cash flow that year. Of course, this also varies from company to company based on a lot of variables, but the rule of thumb here is that AISC is an under-reporting of how much it costs to profitably mine gold over the long term. A good sanity check is to look at 3 or 4 of the top gold producers occasionally, and see if they currently have a lot of positive free cash flow as a group. This can give you a hint as to whether gold is overvalued or not.
The point is that gold does have a rational price range. If it goes under $1,200 per ounce, the less efficient gold miners may start cutting operations, thereby reducing global gold production, which helps keep a natural floor to how low the price of gold should go. If it goes under $1,000, then even more efficient gold miners would have trouble being profitable. There’s no hard floor to the gold price but the lower it goes, the more production would be reduced, which would have a gradual upward effect on the supply/demand balance.
The total amount of gold cumulatively mined since the dawn of time is impossible to measure for sure, but is widely cited as being under 200,000 tons, and in terms of volume less than a cube that is 25 meters on each side. That’s a tiny volume of gold for the whole world.
The peak discovery year for gold was in 1995. Despite more money being spent on exploration costs, the industry has never found as much gold in one year as it did that year, and this has been a clear trend in discovery charts. And it takes about two decades to turn a gold discovery into an active gold mine due to the difficulty in getting regulatory permits and the lengthy construction process of building infrastructure for a gold mine.
Because of this, many industry experts expect us to be at around peak gold production right now, during 2015-2020, because we’re about 20-25 years after that peak discovery in the mid-90’s, when maximum production may be coming online along with moderately high gold prices that justify the output.
So, going forward, we may have reduced gold production.
However, unlike oil, gold can be recycled and reused, as it is melted down and remolded into new uses. Therefore, the total amount of usable gold in the world will likely continue to gradually increase, even if annual production slows down.
The AISC per ounce can and will change over time, as well as the free cash flow breakeven value of gold, so an investor must pay attention to the reported AISC of top gold miners and current free cash flow to know where a reasonable floor price for gold should be. And of course, gold can indeed drop well below this natural floor price. But long-term, unless something dramatically changes about the economic value of gold, it should rebound back above the price it takes to mine it, and thus any major dip should be temporary, even if “temporary” might mean several years.
The amount of gold mined worldwide in each year is less than 2% of total existing above-ground gold in the world, and gold is not significantly used by industry. So, if demand for gold falls, there are already hoarded stockpiles of it, and production could decrease for years.
AISC and free cash flow analysis on gold companies can give us a good understanding of what it takes to mine gold, but due to the unique aspect of gold being hoarded more than other materials, and serving more as a universal backup currency than as an industrial commodity, it could conceivably drop below AISC for quite some time, although almost certainly not forever.
If gold miners were to shut down, the existing gold supply would become fixed, even as human population and the money supply of various currencies around the world keep increasing. If gold production were to halt for, say, five years due to unusually low prices, there would be about 10% less gold in the world than there would have been if mining had never halted.
In contrast, during 2010-2013, gold prices entered a local bubble as it passed $1,400 per ounce and went to over $1,900 eventually, before coming back down. Television commercials convincing the public to buy physical gold were seen everywhere, and they even started installing gold vending machines in certain areas.
When gold has a big run like that with a lot of enthusiasm, be cautious. And when gold prices go way higher than gold mining costs and when gold companies are reporting billions of dollars in free cash flow, be cautious. But in normal times, when gold is reasonably priced or undervalued compared to its mining costs, it makes for an excellent target for option weaving.
The primary use of option weaving into and out of gold is to generate a moderate amount of income on something that is not correlated with your equity positions. Gold usually rises in price during market corrections, when equities fall. There’s no guarantee this will be the case every time, but since gold has intrinsic rarity, people often turn to it in times of volatility and fear.
By having a small or moderate chunk of your portfolio allocated to gold, your portfolio will likely be less volatile than a full equity portfolio. When equities fall, you can sell some of your gold position (which likely appreciated in price at that point), and buy those undervalued equities. And by option weaving the gold, you can get paid an income to own it.
Gold Summary Table
With this option-weaving approach, we don’t necessarily need to accurately value gold, and that’s a fool’s errand anyway. All we need to do is conclude whether it’s highly overvalued or not, which is a much more forgiving task. If it’s not overvalued, then option-weaving with it is safe.
This is the rough rule of thumb that I approach gold investing with:
AISC = All-In Sustaining Cost (per ounce)
FCF = Free Cash Flow Breakeven Point (per ounce)
Gold Price Chart = Current gold price vs historical inflation-adjusted gold prices
(“<” means less than, “<<” means much less than)
Increasing exposure to gold in this context can mean a few things. First, it means increasing the absolute and relative size of your position, such as selling more puts and calls on GLD. Secondly, it can mean that when you do sell puts, you sell them even closer to the money for higher premiums, and when you sell calls, you sell them a bit further out of the money, to give gold a bit more room to run upwards before expiration.
Reducing exposure to gold means decreasing the absolute and relative size of your position, such as selling fewer puts and calls on GLD. It also means that when you do sell puts, you sell them at a bit lower strike price in exchange for lower premiums, and when you sell calls, you sell them very close to the money or at the money to get higher premiums.
I often visit Macrotrends. I highly recommend it, because you can easily see free information on various historical metrics and how they’ve changed over time, such as the historical inflation-adjusted price of gold, the historical inflation-adjusted price of silver, the historical gold-to-silver price ratio, the historical gold-to-oil price ratio, the historical gold-to-DOW price ratio, the historical gold-to-money-supply ratio, etc.
You can determine which metrics are most important to you when valuing gold, to make sure that your level of exposure to it matches what you perceive the risks to be.
Silver Investing 101- Uses and Valuation
Silver is the most electrically and thermally conductive of all metals- even more so than copper. But unlike gold, it tarnishes easily.
Silver is used in trace amounts in just about every electronic device out there and plenty of other industrial applications such as in glass and solar panels, and is more of a functional metal in practice than gold is.
This sounds like a good thing, but when a recession hits and economic production goes down, the industrial demand for silver falls, and the price of silver usually falls. This makes it too correlated with equities to be useful for this primary purpose of offering downside portfolio protection. This is true for platinum and palladium as well; they generally decline in price during recessions like equities because they are used in industry, such as for catalytic converters on automobiles.
The “good” news about silver is that it’s more volatile than gold. That means the option premiums and income you get from option-weaving into and out of it are higher than with gold. For patient, long-term investors, volatility is a good thing.
In terms of valuing silver, you can follow a similar approach as with gold. Pay attention to current AISC of silver per ounce, and compare the current price to its historical inflation-adjusted price.
The Gold-To-Silver Ratio
Going back thousands of years, gold was traditionally valued at 10-20x as much as silver. Although there were some temporary anomalies, the ratio always reverted to being in that range whether you look at Greece, Rome, Japan, China, or the Middle East over any sufficiently long stretch of time.
During the early years of the United States and during Napoleon’s reign, the price ratio was set at about 15-to-1.
During the past century, though, the ratio has averaged about 50-to-1, which is far higher than in thousands of years of global history. But in this past century, it has varied between 10-to-1 and 100-to-1. Gold is volatile and silver is even more so.
During 1980 and 2011, when gold spiked to its highest inflation-adjusted levels in modern history, silver spiked even higher (relative to its normal price), and closed the gap to under 15-to-1. However, during periods where both gold and silver were cheap compared to their historical averages, gold’s ratio to silver would increase over 50-to-1, sometimes peaking up to 100-to-1.
Even in just the last 10 years, the price ratio has varied between 30-to-1 and 80-to-1. As I write this in June 2017, the ratio is about 75-to-1. Gold is historically overvalued compared to silver right now, and silver is not too much higher than its AISC. Thus, I’m bullish on silver.
Interestingly, although silver is about 20x as abundant in the earth’s crust as gold, it’s a lot less than 20x as abundant as gold above ground. That’s because gold is hoarded by central banks and governments, while silver is not. Very little silver is owned by those massive institutions, and it’s more dispersed in electronics, glass, silverware, jewelry, medical supplies, and other things. Much of it gets thrown away, when windows and electronics are tossed away. Nobody throws out gold in large quantities, though. It’s a lot harder to estimate the amount of silver in the world, whereas there is a fairly tight consensus estimate for how much gold there is.
If anything, that justifies the historical ratio of about 15-to-1. But, for one reason or another, the price of gold has recently outpaced silver. Their supply and demand forces are governed by different markets, and their mining characteristics and costs are different.
During times where you notice that silver is reasonably-valued or undervalued in terms of 1) historical inflation-adjusted price, 2) gold-to-silver ratio, and 3) current AISC of silver (and silver companies not making a lot of free cash flow), it can be a good strategy to option-weave into shares of SLV.
Warren Buffett’s Silver Investment
The Oracle of Omaha has critiqued commodity investing with a lot of memorable quotes.
My favorite has to be this one:
Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.
It’s a relatively unknown fact, though, that Buffett did invest in silver once, despite all his criticisms of commodity investing. And he did so profitably.
Specifically, through his company Berkshire Hathway, he bought about 4,050 tons of silver during a period between 1997 and 1998.
When everyone else was buying wildly overvalued tech stocks during the Dotcom Bubble, Buffett was instead buying cheap things like silver. Berkshire officially stated that the reason for the purchase was that due to the supply and demand characteristics of silver, they expected it to appreciate in price. In other words, they correctly thought it was undervalued.
Due to the sheer volume of silver acquired in the course of a year, some people accused him of manipulating the price of silver. His company later sold it for a higher price than it was purchased for, and it was a profitable investment.
This whole event is mainly just a fun fact. But it’s an example of how, although gold and silver do not produce cash flows, there is still some semblance of a way to value them. A smart investor will identify undervalued or reasonably priced assets in all sorts of different areas.
Why Miners are Risky
You can use an option weaving strategy on major gold mining companies, and miners are quite correlated with the price of gold.
However, gold miners are levered against gold. Whereas the price of gold might double or halve over a period of several years in extreme cases (from, say, $800 per ounce to $1,600 an ounce, or vice versa), gold miner stock prices could go up or down 5-10x. As such, their option premiums tend to be high.
Suppose a gold miner has a free cash flow breakeven point of $1,000/ounce, so when gold is above that point, they have positive free cash flow. In simple terms, if the price of gold is currently $1,100/ounce, the gold miner is making about $100/ounce in profitable free cash flow per year for each ounce they mine. If the price of gold jumps to $1,500/ounce and the gold miner’s expenses stay the same, they’re suddenly making $500/ounce in profitable free cash flow. Their profits jumped 400% even though gold only rose 36%. If gold then falls to $800/ounce, the gold miner goes into the red and starts losing money fast and piling up debt and falling to a rock bottom share price.
If you’re an investor in gold itself, you can wait out any downturns in gold price and just keep collecting option premiums on it until you eventually sell it at a higher price. You can do this for years and years if you want, just holding it and getting paid constantly.
But gold miners aren’t so comfortable; if gold stays low-priced for long, they can go bankrupt before the price of gold rises again. As previously described, it certainly is possible for gold to drop below AISC for years if for some reason demand falls, because annual production only equals about 2% of the current gold supply.
In other words, the market can stay irrational for longer than miners can stay solvent.
In addition, gold miners are historically not well managed. They don’t keep costs under control, and so they tend to miss out on the most profitable spikes in gold prices. They often make poorly-timed acquisitions when precious metals are highly priced, which turns into a value trap when the prices fall back down to normal.
That’s not to say that gold and silver miners are never a good investment- they certainly can be. I’ve invested in gold miners before. But unlike investing in GLD and SLV ETFs, I don’t consider miners to be conservative investments.
Precious metals are useful as a separate asset class from stocks and bonds, and are partially uncorrelated and instead have their own unique risks and opportunities.
This makes them particularly suitable for using as part of portfolio diversification strategy. There are many ways to invest in gold and silver, but this method of option-weaving can provide a lot of investment income. You cap your possible upside compared to a speculator, but in return, this part of your portfolio can churn out regular option premiums while keeping some of your assets outside of stocks, bonds, MLPs, and real estate.
Right now, the CAPE ratio of the S&P 500 is historically high, which is not a good thing for the long-term rate of return of stocks. Silver, however, is rather reasonably priced according to many metrics. Therefore, I currently have some of my assets in silver.
In my free newsletter, in addition to discussing the markets and various stock opportunities, I keep readers up to date every month or two with my own precious metal investing, including what specific positions I currently have. If that’s of interest to you, make sure you join.