GRAHAM BARR AND BRIAN KANTOR: A golden option

In a previous issue of this magazine we discussed how the ever-changing probabilities of future events make the risks that face financial markets hard to measure and incorporate properly in share selection.

If a successful share investment has yielded an excellent return, was it because the shareholder took on extra risk and got lucky, or was it because the savvy investor knew the share was undervalued and proved that to be the case?

Financial instruments in the form of traded options to buy or sell shares or metals exist in the market, and can materially change the risk associated with any position taken.

These options can be used to either lower the cost of taking a risk on a future position, or lock in an existing gain without liquidating the current position. “Call” or “put” options on a share are instruments that give the owner the option to buy or sell a share or asset until some designated time in the future, at a predetermined price.

Call options can deliver multiples of the gain realised by a particular share for a much smaller outlay of capital, thus providing low-cost insurance against a strong upward run. Put options, in contrast, can provide insurance, again at a low price, should the underlying share or metal price fall. As with most insurance, it is best to pay the premium and not have to collect.  

Option prices exhibit a much higher level of variability (or risk) than the underlying share (or asset). These traded options, though highly geared to their underlying asset price, have no value after their expiry date, but can still give investors an excellent opportunity to raise expected returns, with no significant effect on risk.  

Holding gold metal is a common portfolio hedge, as the gold price tends to rise in periods of uncertainty, when other assets fall in value. Gold shares, of course, offer a similar, but more highly geared, alternative. That’s because gold mines have stores of unmined gold in the ground that become more profitable to mine as the gold price rises.

Therefore, the value of a share in a gold mine tends to rise or fall by a multiple of the movement in the gold price. An option to buy or sell a gold share then represents an even more highly geared alternative.

The recent sharp move up in the gold price is a good example. It has rallied 10% or so in dollars over the past year. Yet the share price of Gold Fields (GFI) has moved up about 100% (a factor of 10 of the actual gold price movement) over the same period.

A short-duration call option on GFI, in turn, will have moved up about 500% (a factor of 50 of the gold price movement). If you had considered hedging a portfolio by having 10% of the portfolio in gold bullion, you could have equivalently hedged the portfolio with only 1% of the portfolio capital invested in GFI, or even just 0.2% invested in a GFI call option.

By buying the share and, particularly, an option on the share, you will have exposed significantly less actual capital and obtained the same hedging effect. If you had held 0.2% of the portfolio in GFI options, you got the same hedging effect as holding 10% of the portfolio in gold coins. If the gold price had done the opposite, and fallen 10%, you would have lost 1% of the portfolio capital if you had held gold coins (a 10% fall for 10% of the portfolio), but only 0.2% of the portfolio capital, comprising the outlay on the GFI call options (which would have become worthless).

Therefore, you would have been unambiguously better off holding the gold share options rather than the gold coins or the share. This means that a portfolio manager who is a gold bull and is already committed to holding a large amount of bullion can turbo-boost an investment in gold, with little added risk, by purchasing a small (value) amount of highly geared gold share options.

Unfortunately, such strategies are complicated for the average private investor. The options market is very much a wholesale market between banks and pension funds. But it seems that it would be straightforward for financial innovators who write structured products.

A product could include call options for the upside and completely offset the downside losses, representing the price of the call option, by also including an accrual (zero-coupon) bond which would mature at the same time as the call option expiry. The monetary value received for the maturing bond would then be used to offset the cost of the option.

The product could then comprise a mix of, say, 90% gold bullion and 10% gold share options of appropriate duration along with the zero-coupon bonds. This tradeable security would exhibit high leverage on any gold price upside, but for a much lower risk of losing capital. 

Barr is emeritus professor of economics and statistical sciences at UCT; Kantor is emeritus professor of economics at UCT