In the past, structuring bullish gold products had been difficult because of its relatively high volatility and the fact that its forward price is always higher than its spot price. "If an investor wants full 100% principal protection, not contingent via airbags, the participation rates are inevitably low," says Garry Frenklah, head of non-Japan Asia private banking sales, equity derivatives and FX/precious metal derivatives at RBS.
In other words, investors have to sell a lot of their upside to make the option they're buying affordable. According to Frenklah, investors buying a one-year structured note expressing a bullish view on gold will get paid just 35% of the underlying price rise in today's markets û if gold hits $800 an ounce from its current price of roughly $710, the structured note investor will pocket $31.50 of the $90 rise.
Cheaper principal protection would be a big hit with investors because the gold price has been relatively unstable all year, sawing back and forth between a low of around $610 in January and a high of around $714 last week. Gold is also incredibly expensive right now. In January 1980, the price briefly soared above $800, more than doubling the previous year's average, but apart from that two-day spike, gold is now at an all-time high in US dollar terms.
This combination of volatility and record-high prices makes investors nervous enough to want principal protection, but many are also well aware of the potential for further gains. Analysts agree that wild markets, a weak dollar, high oil prices and falling interest rates should work together to push the price of gold higher still.
Indeed, Philip Klapwijk, executive chairman of precious metals consultancy GFMS, pointed out in a report that the recent volatility in gold prices was caused by external factors û mostly by investors caught up in the subprime mess selling gold to fund their losses or deleverage their credit exposure. "We may not be completely out the woods as regards speculator sell-offs to raise cash or reduce leverage in our new world of sub-prime jitters," he said at a seminar in London last week. "But the norm of safe-haven buying should dominate investor activity from now on."
If that view is right, now could be the perfect time for investors to buy bullish structures. "The current market turbulence has resulted in a volatility skew whereby front-month volatility is inordinately higher than that of further months," says Frenklah. "Investors' benefit from selling this short-dated volatility is a massively improved participation rate for a one-year US-dollar 100% principal-protected structured note bullish on gold û from 35% to 125%."
RBS traders say the volatility spike is overdone and that investors should be selling volatility at these levels. With markets the way they are, they can enjoy an unusually high knock-out barrier of 110% of the spot price (currently around $710). That is to say, the price of gold would have to reach the $780 mark û a level not seen since the spike in 1980 û before investors got knocked out and received only their capital back.
And although this is a one-year investment, the knock-out only applies to the first six months û if investors survive that window without being knocked out, they get paid 125% of the upside in the price of gold at the end of the investment. This window gels neatly with the consensus view too. At roughly $710, the price of gold has already reached most analysts' projections for the year-end price of gold, implying relative stability for the next few months. But the longer-term upside for the price of gold ranges anywhere from $800 to $3,000, depending on which analyst you believe.
"Every once in a while a Eureka trade idea is developed that makes you sit up and go 'Wow'," says Frenklah. "For me, this is one of those occasions."