By Brad Zigler
There was a common theme in the trickle of gold miners' earnings released last week. In a word: "disappointment."
"Gammon Gold's Q2 Disappoints" read one headline. "Disappointing Quarter for Newmont" blared another.
So what do you do when your gold stock disappoints you?

That really depends upon your tolerance level. Some investors can accept a fair degree of interim volatility while awaiting their price objectives. Others keep their risk budgets tight, perhaps bailing when a predetermined stop-loss point is reached.

While short-term blips are par for the course in any stock holding, gold miners are inherently more volatile than the broader equity market. This year, returns on the NYSE Arca Gold Miners Index stocks have gyrated nearly twice as much as those on the S&P 500 Index.

Financial advisers constantly tell clients that money's more likely to be made by buying and holding issues rather than engaging in in-and-out trading. There's something to be said for such advice. Empirical studies have shown investors, by and large, are lousy market timers.
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But buy-and-hold's much easier if you can lay off some of your price risk in exceptionally volatile times, like earnings seasons. This week, for example, as more companies released their results, the gold market took a couple of gut punches. Bullion sold off 3%, while gold miners slid 7%. Stocks making up the Gold Miners Index will be dribbling out earnings over the next two weeks, so continued downside volatility could prove very costly to some high-cost basis shareholders.

Recently, financial firms have churned out waves of leveraged and inverse funds, some of which are marketed to compete directly with futures for hedge interest. Before using these products to mitigate risk, though, side-by-side comparisons ought to be performed to assess their cost and efficiency. Their utility may not be greater than that of more seasoned products.

As an example, let's look at the hedging options that could be used for Gammon Gold Inc. (NYSE: GRS). Gammon is a volatile issue and not exceptionally well-correlated to either the general equities market or to bullion. The stock's price swung between $2.28 and $10.20 over the past year, generating a nail-biting standard deviation of 94%. Stacked up against tradable proxies for the S&P 500, the NYSE Arca Gold Miners Index and bullion, Gammon's a particularly challenging hedge.

Not surprisingly, Gammon has a low correlation to the large-cap domestic stocks, as represented by S&P Depository Receipts (NYSE Arca: SPY). A little background: Correlation gives us an idea of the relationship between two securities' price histories, but it has little, if any, predictive value. A correlation value of 1 represents a perfect positive relationship, meaning the securities' prices consistently move in the same direction. A perfectly negative correlation (-1) means the securities constantly move in opposite directions, while a 0 correlation expresses no relationship at all. The absolute value of the correlation (that is, the reading's distance from zero) expresses the strength of the relationship, with 1 being strongest and 0 being weakest.

Gammon, as was evident from our analysis, is most strongly correlated to the Market Vectors Gold Miners ETF (NYSE Arca: GDX), a portfolio tracking the NYSE Arca Gold Miners benchmark. It also demonstrates a middling relationship to bullion, as proxied by the SPDR Gold Shares Trust (NYSE Arca: GLD).

Beta describes the riskiness of a security compared to a market benchmark. Think of beta as a measurement of a security's relative volatility. Like the correlation metric, beta can be positive or negative denoting the relative direction of price movements, but unlike correlation, beta values are limitless.

Note, for example, the 1.47 beta exhibited by Gammon versus bullion (GLD). This tells you that Gammon has been a riskier holding than bullion. Put simply, when gold rose 1%, Gammon's tendency was to go up 1.47%. Likewise, a 1% decline in bullion's price was likely to have been accompanied by a 1.47% decline in Gammon's value.

In our analysis the standard deviation measured the annualized price volatility of a security, derived from its daily fluctuations over the past year. Of the three benchmarks examined here, GDX, with a standard deviation of 80.6%, is closest to matching Gammon's variance (94%).

So if you wanted to hedge a long-term holding against short-term downside volatility, you'd take an opposite position in a closely correlated security or derivative for the duration of the anticipated danger, then peel off the hedge to resume your naked posture. The size of the hedge relative to your stock holding determines how much "insurance" you'd seek for the period.

Hedging with GDX, for example, would start with determining a hedge ratio. Let's say you owned 1,000 shares of Gammon a year ago when the stock was worth $9.03 a share (it's now trading at $6.93). If you had the information, you might construct a full hedge with GDX by first determining how much of the ETF to short (remember, we're taking an opposite position here). You'd beta-adjust the size of your hedge to compensate for the securities' different volatilities, allowing you to conserve capital, as we'll soon see.

($9.03/share x 1,000 shares) x .76 GDX beta = $6,847

With GDX selling for $44.26 a share one year ago, your hedge would have required selling short 155 ETF shares. With a Regulation T requirement of 50%, that could take as much as $3,430 in capital (assuming no other margin account equity).

Over the course of the ensuing year, Gammon's lost 23.3%, while at the same time, GDX gave up 13.6%. Hedged with a short GDX position, however, you would have lost only 9.4%. While you would have given up some lucre over the course of the year, your losses would have been less than those sustained by holding naked stock.

This protection, however, comes at a cost. When the hedge was placed, the $3,430 Reg T equity requirement represented 38% of your Gammon position's value. The hedge's cost/benefit ratio - 2.7-to-1 - can be determined by dividing the cost (38%) by the 13.9% loss "saved" (the hedge benefit). When comparing potential hedge strategies, you'll want to find the approach with the lowest cost basis in most cases.

If you'd elected to use GLD for a full beta-adjusted hedge instead, you would have shorted 145 shares and managed to pare your loss to 13.8%. With a cost of 73.6%, your ratio would have been a relatively inefficient 7.8-to-1.

Keep in mind, as with all insurance decisions, you can control your costs by accepting a certain degree of "self-insurance." In the casualty world, you do so by adjusting your deductible. In investment circles, it's done by modifying the size of your hedge. You could, for example, opt for only a half-hedge if you were more sanguine about pending market risk. For the GDX position described above, the half-hedge option would mean shorting only 78 shares (155 ÷ 2).

Recently introduced short and leveraged exchange-traded notes offer hedging opportunities without the need for a margin. This makes them ideal for hedging assets in retirement or fiduciary accounts. These portfolios can be inefficient, however.

Take as an example the PowerShares DB Gold Short ETN (NYSE Arca: DGZ). Think of the DGZ portfolio as "opposite gold"; its beta is the inverse of GLD's. Given its year-ago share price, a 516-share long position would have fully hedged your Gammon holding. With DGZ's 7.5% loss for the year, a short position yielded hedge protection similar to that offered by GLD - a net 13.8% loss - but at twice the cost of the GLD hedge. In fact, the cost of the DGZ hedge would be greater than the cost base of the Gammon stock being hedged.

DGZ's levered sibling, the PowerShares DB Gold Double Short ETN (NYSE Arca: DZZ), is designed to offer twice the inverse return of the index shared by the two portfolios. Because of the leverage involved, beta-adjusting a hedge position isn't practical. Portfolio characteristics derived from daily returns (as employed here) can produce anomalous results when leverage is introduced. Thus, Gammon's beta versus DZZ, at -8.5, is singularly unhelpful in establishing a hedge ratio. Instead, you'll need to use the two securities' standard deviations to determine a hedge ratio:

94% (GRS standard deviation) ÷ 64.4% (DZZ standard deviation) = 1.45

Thus, after applying the hedge ratio calculation utilized in your other hedges, you'd determine that a full DZZ hedge would have required 298 shares a year ago. The resulting outcome would have been dramatically better than the other hedge alternatives. DZZ gained 27.4% on the year, slashing the net loss on the hedged Gammon position to only 2.6%. The high cost of the hedge (at 69.1% of the stock's value) could make this insurance impractical, though. The cost/benefit ratio, at 3.3, is in fact marginally poorer than that of the GDX hedge.

Still, for an account that can't use margin, DZZ may be the only, albeit more expensive, choice. For all other applications, provided you're otherwise suitable for margin trading, GDX may be your best hedge bet for your gold mining shares. (Courtesy: Hardassetsinvestor.com)