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posted on 27 October 2016

Gold That Pays Dividends

by Russ Allen, Online Trading Academy Instructor

Online Trading Academy Article of the Week

I’ve written here before about the importance of diversifying your portfolio. It is vital to avoid having all of your net worth exposed to any one market, especially the stock market. Other possibilities include bonds, real estate, commodities, cash in the bank and precious metals. A good mix of these will make it more likely that your overall portfolio will grow steadily over time.

Below are charts of returns for the last twelve years for three exchange traded funds, representing stocks (red), bonds (blue) and gold (green). All three show substantial returns over the period. All three have had their ups and downs, but very seldom have the downs come all at once for all three.

How to use EFTs to earn dividends.

Over this period, the one with the highest overall return has been gold. This is true even though it peaked out five years ago and has lost 35% of its value since then. It appears to be on another upswing now. It is certainly never going out of style. As long as central banks have printing presses, inflation is a reality for the long term. And gold, as the ultimate “hard asset" is very likely to trend higher over long periods of time.

Investors can own gold in physical form as coins or bars. They can also own gold futures, gold-based mutual funds or gold-based exchange-traded funds. Of all these forms, there is one that has a special advantage: it can generate cash flow on gold that you own. The lack of cash yield is otherwise a disadvantage of owning gold.

The way to make an investment in gold generate cash is to own it in the form of exchange-traded funds and to periodically sell call options on those ETF shares. There are several gold ETFs that will work for this purpose. All of them own gold equal to some fraction of an ounce for each share.

The oldest and largest of these is GLD, the SPDR Gold Trust. Each share provides indirect ownership of 1/10 of an ounce of gold. The shares rise and fall in tandem with the price of gold.

There is an active market in the options on GLD. As of today, the share price of GLD was about $121. Call options expiring a month out at the $125 strike price could be sold for about $.60 per share, or roughly ½% of the value of the shares.

Here’s how the covered call would work: To buy 100 shares of GLD today would cost $121 times 100, or $12,100. A single call option could then be sold for $60. Here is how this would then work out depending on where the price of GLD went in the next month:

  • GLD stands still at $121 per share. You neither make money nor lose money on the GLD shares. But, you keep the $60 you received for the call which expires without being exercised. You make a ½% return in a month, equivalent to a 6% annualized return.

  • GLD goes down. You lose on the GLD shares but that loss is at least partially buffered by the $.60 per share you received for the call. You do it again next month. Every time you sell a call, you reduce your effective cost of the GLD shares and therefore your break-even price.

  • GLD goes up a bit, not as high as $125. You make money on the GLD shares. The call is not exercised and expires. The $.60 is still yours to keep in addition to the profit you made on the shares, pumping up your return by an extra 6% annualized. You do it again next month.

  • GLD goes up to $125 or higher. In this case the call option is exercised. You give up the GLD shares and receive another $125 per share. Your total proceeds are $125.60. Since your original cost was $121, this is a profit of $4.60 per share. This is a 3.8% return in one month, or 45% annualized. This is the brass ring - or in this case the gold ring. You then wait for GLD to make a pullback into a good demand area, buy the GLD shares again and start the process over.

In this way you can invest in an asset that moves differently than the stock market and make some cash flow for doing so, in addition to any long-term appreciation. The small amount of work that is required to sell the new calls each month can be more than worth it.

Selling covered calls is not limited to GLD of course. It works for any stock or ETF that has attached options. It is well worth investigating as a solid investment technique to add to your arsenal.

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