4 minute read
Smart Inflation Hedges
from December 2021
ADVANCED
Looking to take the sting out of an investment’s shrinking value? Ethereum and bitcoin have been anything but stable. Think gold.
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By Michael Rechenthin
I
s cryptocurrency the new inflationary hedge? Not for anyone who worries about a 5% drop in purchasing power. Ethereum has had losses that big roughly once every two weeks (or 10% of the time).
What’s more, hedging is supposed to reduce risk, and ethereum and bitcoin have been anything but stable.
See “Going down,” right, for more stats. The table shows the percentage of days ethereum, bitcoin and gold have fallen by a given amount during the past two years. Value at Risk (VaR), a statistical measure of the risk of financial instruments or asset portfolios, shows significantly more risk in the cryptos as well.
VaR is defined as the maximum dollar amount (or percentage) that investors can expect to lose during a one-month period with a high degree of confidence.
Looking at ethereum over the course of a month, a loss of $2,500 on a $10,000 investment would not be out of the ordinary. For gold, the VaR is only $500. See “Measuring riskiness,” right.
For those seeking relative stability or asset preservation during inflation, gold is the better bet.
Investors have two popular choices: the SPDR Gold Trust ETF (GLD) or the slightly less popular iShares Gold Trust (IAU). They have similar constructions, and both are based on the price of gold. IAU’s lower price makes it a better choice for smaller investors.
But instead of just purchasing gold, try the following covered call strategy. It provides a high probability of success and the advantage of additional cash flow.
The cash received on the short call amounts to an annualized return of 13%, and that helps reduce any drawdowns gold may have.
Take a look at the trade and stats in “The covered call,” p. 63. For another view on hedging inflation, see p. 36.
Michael Rechenthin, Ph.D., aka “Dr. Data” is the head of research & development at tastytrade. @mrechenthin
Going down
Bitcoin and ethereum may beat gold in the long run, but both cryptos have bad days in the market more frequently than the precious yellow metal does.
Ethereum Bitcoin
Percentage of days when prices fell 2% 26% Percentage of days when prices fell 5% 10% Percentage of days when prices fell 10% 3% 21%
7%
2%
Gold
26%
Rarely Happens
Rarely Happens
Instead of buying gold to keep pace with rising prices, try a covered call strategy.
Measuring riskiness
Value at Risk, or VaR, denotes riskiness and indicates crypto’s not for the faint of heart.
One month Value at Risk (VaR) VaR as a % VaR as maximum drawdown to expect on a $10,000 account
Ethereum Bitcoin Gold
- 25% - 20%
- 5% $2,500 $2,000 $500
The covered call
The trade
Maximum gain
Breakeven
Maximum loss
Buy 100 shares of iShares Gold Trust (IAU) at a price of $34.10. Sell the 35 call in January for 0.60.
$150, which would occur if the stock is at $35 or higher by January’s expiration. This would be an annualized 20% return on capital. The probability of achieving max return on the trade is roughly 35%.
The breakeven would be the current price, minus the money received from selling the call. In this example, it would be 34.10, minus 0.60 = 33.50. The position would experience a loss below that price.
Theoretically, gold could go to zero, which would result in a loss of $3,350 (or the cost of the position). Realistically, there is only a 20% probability of experiencing a loss greater than $100 on this trade.
Money required In a cash-secured (non-margin) account, it would be 34.10 - 0.60 x 100 = $3,350. In a margin account, investors could accomplish this for $1,700.
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