There are three types of volatility: Implied, realized, and future.
Realized is a measure of how much movement there has been during some time
period in the past. Implied volatility is the price of options now, which is in
some sense a forecast of what future volatility will be.
As a full time options trader, I spend a lot of my time
dedicated to searching for patterns that give me hints of what future volatility
will be. Looking at the charts and order flow among other things, I use the
price of options and my expectation of potential moves to allow me to enter
into a trade.
Take a look at the
chart above. This is the 9 month daily chart of gold. In January gold made a
high of 1307. It sold off rather quickly to 1142 (165 lower, or about 12%) in
the course of about 50 calendar days. Take
a look at where gold options are priced.
Gold implied volatility is currently trading around 16.5%
for options expiring in 60 calendar days (November exp). If memory serves,
volatility was priced similarly to where it currently is when gold was trading 1300. As I write, the 40
dollar lower put in gold expiring in 60 days (the November 1095 put) costs about 15 dollars. If it were to be compared to the equivalent put when we were
trading 1300 in January, this would be approximately the 1260 put. That move (1300 down to 1140) took place in 50 calendar days.
Here is the trade in retrospect:
15 dollars of premium spent; if the put goes in the money
and you cover at expiration, each put you bought will be worth the strike price
minus where gold is trading. So, in our example case, where gold moved from ~1300
to ~1140 in 50-60 days, we buy the 1260 put for 15 dollars. On expiration, we
are trading around 1142. (1260-1142=118). You spent 15 dollars for a trade
worth 118, so you make (118-15) 103.
As a high schooler and college student I played poker as a
means of affording some basics. I would rarely play games where I won or lost
more than $1000, but it was my young version of trading. Poker taught me one
incredibly important thing that I use in my job to bring me back to reality. If
you know the implied risk reward of a situation, and understand some basic math, you can become a winning player. Whatever noise markets are blasting in our ears, we must ask ourselves if the risk reward makes sense. If we are not convinced that it does, or that a trade makes sense but comes with a caveat, it is not worth doing.
In our above example, you would have made a return of
approximately 103 dollars on a bet that cost you 15 dollars. You could not lose
more than the $15 you put up because you were the buyer. So, you made 103. To
calculate the risk reward, we should ask what the number of outcomes like this
we would need given this price for the option to break even.
Put more simply: we bet 15 dollars; we made 103. (103/ 15 =
6.8) So if you had an outcome this favorable one out of every 6.8x, this bet
would be fairly priced. (6.8x you pay 15 dollars, so you spend 103 on making
the bet, if you win once in those 6.8x you will have won what you paid to enter
making it “fairly priced”)... there are more outcomes than this, but if it is a move hard or sit scenario, this kind of math is more applicable than would be in a whippier market like crude.
I will not say what makes gold options fairly priced; but as
an options buyer you can wait until situations are favorable from a risk reward
perspective given your understanding of historical pricing. You are in no rush
to make bets. If you are, step back, that kind of mentality is what allows the
options sellers to hold onto their profits despite selling vol many times in
the last year below where vol was realized.
All of the charts I show are in an effort to show and
determine what I see as patterns of buying and selling. If we can find lines,
however random, that indicate to us the potential for consolidation, it makes
the prospect of owning options all the more dangerous. If you paid similar prices
for the option we just discussed from any time between late March and June you
probably lost all of your premium. To make on that trade, your timing would’ve
had to have been perfect.
Creating a fair price for gold options over a 4 month period can be very tricky. The market can sit still for months and then move quickly all at once. Most of the time it is actually overpriced, but the times it is underpriced, it is drastically underpriced. If you look at the chart, and assumed you could not time things, but
rather made the same bet time and time again, you probably made a little bit
over time. You would not have made enough
to justify seeking out trades like that. It is the most difficult discipline we
need to keep when trading gold. Even if we are right that gold is going to
collapse or rally 100s of dollars, owning options gets expensive if we are
right a little bit too early.
The longer term (not seen here) chart seems to indicate that gold remains in a downtrend. I last wrote about how I
expected gold to continue to trade higher if the S&P sold off. The relationship
was short lived, once again bringing gold’s safe haven status into question. Funny enough, gold's safe haven bid failed in the 1150-1170 range, which is where it failed when there was the brief and almost forgotten Greece default scare. While this has been a major short covering rally, the gold bulls must have been
disappointed when gold stalled in the 1160s as the stock market continued its
sell off. Below is the 9 day look at gold.
Notice how when gold topped out around 1165 the stock market
had yet to put in its low (the purple line is the S&P) and gold
progressively worked its way lower. While the bulls had a good run there was
serious volume at the 1170 level (sellers defending against a move higher). For now, in the 1120-1135 range, gold sits
right in the near the middle of its recent range (1070-1170) over the course of the last 2
months. It is why I think options buyers need to be patient here. As an options
buyer you have the control. Being profitable requires the discipline to wait for situations where implied vols get relatively cheap, and you have a strong opinion that movement is imminent..
Why is gold volatility where it is right now? Overtime gold
option implied volatility tends to get lower when it trades in the middle of a
range. Why was 1 month volatility trading as high as 18% 2 days ago, when
equivalent volatility was close to 12% before the drop to 1080? The chart
definitely implied a greater chance for a significant move down and quickly at
1142 before 1080 than it does here. While the chances for going lower are still
viable and in my slightly biased opinion probable, betting on having it happen
quickly is challenging. If you are buying 1 month options and you are right
just a month too early, you lose all of your premium. So what to do?
Nothing.
That in fact should be the answer most of the time. Nothing.
There is nothing to do, but prepare for the next trade and wait for the
opportunity that might arise. Gold’s volatility spike was almost certainly due
to the volatility in the stock market. Even while gold stopped negatively
correlating with the S&P gold volatility went out. In fact, gold volatility
got bid as it moved BACK INTO an area (1110-1120) where it has consolidated
before this last leg of the rally. One fairly trustable rule is that volatility
will not get bid if the futures are reversing back into a range. That is
exactly what happened. Vol got bid as we
came back into the range. When the Vix is trading in the 30s, it is not
unreasonable that people who need to own options across markets (for whatever
reason) might reach for some gold volatility. Gold volatility has been trading
at historically cheap levels, and in a time of panic in stocks, it is not
unreasonable for funds with short volatility exposure to buy some gold vol as a
hedge. Gold at 16% as it currently, as opposed to the usual 12-13% we have
grown used to when heading back toward the middle of a range, is not expensive
relative to other asset classes’ volatility. So we are left with a strange
situation in which we notice the inter-connectedness of all assets classes, and
that gold's implied volatility is relatively cheap compared to others. But should the stock market,
and consequently other markets’ volatility settle down a bit (stock up, asset
class implied volatility down) gold volatility should come in as well. If gold
can move quickly in either direction from here, its volatility may justifiably
hold up. But we can only operate on the information we have in front of us. As
option buyers, we must realize that the price action of late does not show us a
clear reason to believe realized volatility will increase. Implied volatility
is also toward the middle-higher end of where it has been on a daily basis for
the last year. Higher implied volatility combined with an unclear signal from
the price action means we should stay away. With lower volatility and gold
closer to either end of the range, options might become very attractive, I
actually think that is likely. So while there are a lot of reasons to see the
potential for gold to move hard in either direction, exercise patience. While I
am sympathetic to the idea that options have been underpriced for a long time
in the gold market, I also know how difficult it can be to manage a position
when nobody cares to buy options. Death by 1000 paper cuts is still death. So
be careful.
I want to reiterate that there
are times when options can become very attractive, but that we need to be very diligent if we want to employ buying options as a strategy. Timing, which is
a big part of successful option trading, is far harder to nail down than people
who do not trade full time might think. Even if you are right over the long
term, the smallest difference in timing can be the difference between a loser
and a home run. I have seen too often the wrong reaction to this reality of
markets. The answer is not that you need to level into positions time and time
again. You don’t need to chase the market. You have to be willing to miss what
look like incredible opportunities. This market has proven that options can get
cheap before big moves. Here, is not the place to put on bets for just that
reason. The medium term implied vol is too high right now relative to its mean,
and the chart gives us no strong reason to feel strongly one way or the other
about direction in the short term. Far too many of the profits I have made on
the big moves have been eaten into by my haste to enter trades that are medium
term smart, but short term stupid. I don’t want others to make the same
mistake.
My hope in writing this article was less to discuss gold
than to discuss some of the classic mistakes people make trading options. I
make them all of the time, even when I am trading well. As traders we cannot control the speed of the market. As such we must always defend against our urge to put aggressive minded positions without strong cues that it makes sense to do so. Making money is no longer a daily expectation in this patient but prudent trading strategy. It would even be OK to suggest option trading
to mom and pop if they understood one simple rule
Never Be Short Options.
If you are a long option/ long spread player you cannot lose
more than the amount of money you put in. “Trading” which involves getting
short options, is a totally different ball game. That is hard enough as a full
time trader, and should not even be considered by a less active player. But for
less active players, I would suggest studying some of the historical implied
volatilities and weigh them against your expectations for imminent movement. If
you can find yourself in a place where the implied volatility is low vs
historical implied vol, and you have conviction of a move, then options can be
a profitable way to play the game. But you have to be selective. Death by 1000 paper
cuts is still death. If you choose to track the market closely, than you will
be able to see situations where the risk/reward to play the game is very
favorable. If you are not willing to pay close attention, you will slowly bleed
buying options in this market.
Be patient, and make sure that if you have a strong
directional opinion that the implied volatility is relatively low compared to
where it has been. If you see that the implied volatility is extremely low
relative to its historical mean, get involved ONLY if you have a real
conviction that it might move.
Markets have been a bit finicky lately, and it is easy to
get caught up in the hype and feel like you need to participate. This can be a
big trap and a more costly one than immediately meets the eye. There are ways
to make money in these markets, but the prudent ones will realize that staying
flat the majority of the time is the smart move now. Opportunities will arise
but we cannot control when they come. If we keep a close eye, we will find
opportunities while others are throwing their hands in surrender having
painfully paid for options right before things calmed down. Things may go crazy
again, but in gold at least, nothing has really changed from a longer term
perspective.
My suggestion? Enjoy the last week or so of summer. Don’t
sit in front of the screen waiting on the next big thing. Stay flat for the
next week and watch how things play out before taking any strong stances.
Historically gold sees more activity after Labor Day than in late August. I
think there will be some interesting stuff forthcoming in this market, and I
will write more if I see anything take place that creates a potential for a
good trade. For those updates, please check in at Fiatgold.blogspot.com.
Wishing everyone a good end to summer.
Ben Ryan
