How to Predict - And Profit From - the Bursting of the Gold Bubble

Gold last week careened to a record high $1,414.85 an ounce in a surge that was sparked by the U.S. Federal Reserve's plan to purchase $600 billion of U.S. Treasuries in a second phase of quantitative easing (QE2).

The yellow metal may have yet more room to run, as uncertainty in the marketplace remains high and the dollar low.

Still, at this pace gold is increasing too quickly to account for inflationary concerns.

That's saying a lot, because there are some pretty serious reasons to be concerned about inflation. With these new rounds of quantitative easing, the massive debt loads the U.S. has incurred, and Treasury Inflation-Protected Securities (TIPS) going into a negative yield structure, you'd have to be a little off to expect stable growth.But gold has a history of bubbles in situations like this. It's a metal that's prone to a little bit of excitement. In the late 1970s the United States was on the heels of an oil embargo, and facing massive inflationary pressures. To help combat inflation, the U.S. Federal Reserve tightened the money supply shooting interest rates through the roof.

Of course, there's a downside to high interest rates when, say, you're looking to buy a house.

Housing traditionally has been the most stable hedge against inflation. Assuming the house is liquid after the round, it appreciates at a rate at or near par with inflation. When interest rates go through the roof, however, it suddenly becomes wholly impractical to buy a house. Few can afford to secure credit at such an astronomically high cost, nor should they.

When real estate becomes impractical to buy, we see a rush to gold. From 1976 to 1980, gold appreciated by roughly 700%, far out of line with long-term inflationary pressures.

Current conditions in real estate and the economy in general have left the market in much the same condition as in the late 1970s. We're facing stagflation as we were in the late '70s, and we're hesitant or unable to buy real estate, just as we were in the late '70s. Gold has appreciated as it did in the late '70s. And sooner or later, as logic has it, the bubble will burst just as it did in the early 1980s.

What to Look For Just Before The End of The Bubble

It's important to realize this bubble burst will happen in stages that depend more on group dynamics than on pure valuation theories.

First, we'll have to see either the restoration in value of the preferred holding for inflationary concerns (like real estate), or the creation of an alternative holding. In short, the money that's tied up in the gold is going to have to be put somewhere else. Moreover, people are going to have to want to put it somewhere else.

Second, we'll have the "fall-guy," or the first of fall guys. It will be something seemingly innocuous: An analyst at one firm calls another analyst's recommendation to buy gold, silver, or platinum "ill advised," and will go on to explain that the commodity is over-invested, simultaneously hocking the alternative store for value. At first, the mainstream will shun the analyst, but other analysts will soon join rank and a full out media blitz will ensue.

Finally, we'll see the sell-off.

Protecting Yourself from a Sell-Off

The downside of bubbles can happen pretty quickly, and being the last person out can mean losing everything. But if you're smart about how you structure your entry and exit, you can make a small fortune from the collapse.

It may sound cliché, but remember to buy the rumor and sell the news. When you see the news on gold start to head south, it's time to consider a change in strategy. It's infinitely better that you capture your gains near the top and miss out on a little upside, than inadvertently give back earnings and not be able to exit cleanly.

If you insist on holding on to your long position through the down news cycle, hedge your position by buying put options. Puts will allow you to hold on to your gains for a modest price. You'll pay a premium to the market, and as a result, you can lock in your gain if you want. If gold decides to take a dive, you can exercise your option and deliver your long shares at the pre-negotiated contract price, or close the put with a call. If gold rebounds through the news, you can choose not to do anything.

Finally, if you're just now investing in gold, take positions that you can easily close.

If you're scared of getting stuck behind a massive sell-off, don't be afraid to buy the calls instead. You can always close out your call and take the earnings before the expiration date. Look for smaller exchange-traded funds (ETFs) that trade at a fraction of the price if you don't have the capital to drop on the larger investments. The percentage gains will stay the same, but you won't have to deal with the massive options premiums. The downside of buying more, cheaper ETFs is dealing with the higher trade commissions. Be sure you weigh your cost of entry.

Capture the Downside

If you're not looking to profit on the downside of a market, you're only considering half of the picture. While betting on the downside requires twice the amount of research, you stand to make twice as much money. When things start to go south, look at these strategies:

First, buy more puts.

Puts become more and more valuable the closer to zero, and farther from strike, the underlying instrument goes. It's important to try to beat the market to the punch when trying to time the purchase of derivatives, though. Smart people write those contracts; they're not in this to lose money. If you wait too long, be ready to pay a premium.

There are two great places to buy puts on the downside of gold:

  • Companies that produce gold.

Companies that produce gold may see a drop in their underlying equity prices as valuations on the companies themselves return to their pre-bubble level. As a result, if you can time the derivative contract at-or-near the stock's high, you could make a pretty penny.

  • Gold ETFs.

Gold ETFs are highly traded, and generally very liquid. People are in gold to make money, and as a result, the derivatives traders keep a close eye on expectations. If you can beat them to the punch, however, you should capture some, if not all, of the downside.

You might also go long on ETFs that short gold.

A reasonable, and often advised, alternative to investing in options yourself is to let someone else do it for you: You can go long on inverse ETFs and exchange-traded notes (ETNs) that are designed to short in a market.

Great examples of these include the PowerShares DB Gold Short ETN (NYSE: DGZ), which mimics a single leveraged short position, and the PowerShares DB Gold Double Short ETN (NYSE: DZZ), which seeks to double the expected gain from a short position.

[Editor's Note: Amos Richards is a former IT professional, who helped with the startup of two middle market Internet companies before attending college. After graduating from the University of Arkansas's Walton College of Business with a Bachelor of Science (BSBA) degree in Economics, Richards worked for A.G. Edwards and Wachovia Corp., which is now a division of Wells Fargo & Co.]

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