A Tough September for the Bulls

When it became clear I would begin trading gold options in September, I immediately imagined what my position would look like 4 days into the job. The one thing for sure was, I would look to buy a lot of calls right away. But like many "sure things", this was not to be.

September is historically bullish for gold. "Buy Rosh Hashana and sell Yom Kippur" as the saying goes. Starting right around the time of Rosh Hashana, in the most bullish (historically) month, with Syria on the table, it seemed logically hard to see gold going anywhere but up. Escalations in the Syria situation or any sort of Middle East destabilization tends to be bullish for oil, and metals prices are certainly correlated to moves in oil. So logically, this looked like one of the bigger layups to buy gold we had seen in some time; but it didn't quite work that way.

The important signal that the bullish thesis was not working was gold's inability to test the top end of it's range in the midst of news that should've brought buying interest to the market. Gold was caught in a range between 1375 and 1425. With Kerry's tough language on the need for action in Syria, the U.S. would look weak were they not to do something proactive. In the end, it is fair to say that the settlement made was just enough to show that action had been taken without really doing a whole lot. And that's fair. Without Britain as an ally (British Parliament voted against getting involved in Syria) Obama realized the potential to be forced to go it alone were "military action" or "targeted strikes" to be the policy option de jour. BUT, that did not become clear until later. Even in the tensest moments, where fear of escalation was highest, gold couldn't even fight its way to test 1425. This should've made the bulls take concerned notice.

Then, what I believe to be the most important event took place. Goldman Sachs talked about gold having hundreds of dollars to drop from current levels. As a simple man, I am prone to look upon recent experience with great gravity when considering the likely next move. As such, I looked back to the last time we came off hundreds of dollars in the spring. What precipitated that? Who knows, but it did just happen that Goldman had called for lower gold just days before we came off. At this point I had seen everything I needed to realize that what seemed to make so much sense, might not be the likely outcome after all. Gold simply wasn't going higher, and I was buying puts that were expensive enough to make managing the position all the more difficult.

Monday and Tuesday of last week featured a clear effort by the algos (or whoever pushes gold these days) to push gold lower. Gold would hang out during the active trading day above support, and then, after the options pit closed, and many had gone home, you would see the futures making new lows. These lows were of course made at times of lower volume, when pushing the market was easier. Tuesday evening, gold was pushed down to a low of 1391.5 on low volume. This number, for those following levels, was completely meaningless. It was between well known support around 1280 and 1300 (the 100 handle's have a way of acting as meaningful levels). Coming into the huge Federal Reserve announcement, where many thought that tapering of bond buying was for the first time legitimately on the table, pushing gold 10 dollars lower should have been a pretty easy task. It never did push lower, and that stands as the low of the move. Gold rallied around 1:30 pm on Fed Wednesday to 1320. Mind you, the Fed announcement was not until 2pm. We had not tested known support only 10 dollars below the over night low, and yet, it was getting bought....then the big announcement of no tapering, and a rally of over 75 dollars from the over night low. It seemed like maybe the bulls were back in the driver's seat. But the bulls only had a short time to feel that glimmer of encouragement.

The overnight high into Thursday's post-Fed day was 1375.4; notice, this is the bottom end of the range that gold fell out of when bulls (my self included early on) were looking toward 1500. So, as an important support level that was broken, 1375 should serve as resistance to the upside. But with more money coming to the bond market, and the promise of lower interest rate's, perhaps gold would break through the resistance and regain its upward momentum. 1375 however, would remain the high, and gold now sits in the 1330s. So where from here is always the question. I believe the likelihood of a big move is much greater to the downside than the upside. Had gold continued to rally after the Fed announced no near term tapering, then perhaps it could've pushed it through resistance levels that really mattered to support the bullish case. But for now, you have to remain neutral to bearish if your looking 100 dollars either way. Gold could rally back to 1375, but even if it breaks to the upside, its breaking right back into the middle of the range that gold spent weeks bouncing around in.... and that makes even the first bull case look unappealing. To put it simply, a series of potentially very bullish catalysts (Syria and the Fed not tapering) were present during gold's most historically bullish month, and it was unable to break back up through resistance. And the cherry on top is that the bank that had correctly called gold's sell off last time (and so far has been right this time) has a target that is hundreds of dollars lower than where it stands today. On a hundred dollar wide outlook from 1335; 1235 seems a lot closer than 1435.

-Ben Ryan

CFTC Steps up fines and penalties, but are they focusing on the wrong things?

http://www.washingtonpost.com/business/economy/high-frequency-trading-firm-fined-in-spoofing-case/2013/07/22/361e26bc-f2d8-11e2-ae43-b31dc363c3bf_story.html

You can find some variation of the above article in multiple news outlets including the Wall Street Journal and the New York Times. I wanted to take a few minutes to write about these fines/ penalties, and how they might be viewed in terms of the overall regulatory climate.

It is hard not to notice the timing of the CFTC's settlement with Panther trading and the release of the New York Times article about Goldman's aluminum warehousing practices http://nyti.ms/18uGD9d. The Goldman article brings into question whether the bank intentionally delays aluminum deliveries to customers for purposes of collecting warehousing fees. That however, is just the springboard for a far larger debate. Should the banks have involvement in these non-financial markets at all, and does it provide them with an "unfair" advantage because they have privileged knowledge? Does a bank that has the capacity to play the role of storage unit (and thus have first crack at information about supply and demand within the market) have an unfair informational advantage that allows them to front-run the paper markets? And if they do (and I would certainly contend that they do) doesn’t that show that efforts at making financial markets a level playing field are failing?

Before getting back to Goldman's aluminum, it is worth taking a look at Panther Trading's settlement. The $2.8 million in fines is no small thing, but the fact that they will have to serve a suspension shows the seriousness of the penalties. What perplexed me about this entire situation is that the type of trading they do is and has been well known to market participants for some time. It is in fact so well known and so accepted as part of what trading has become, that many of the people I discussed it with here (including myself) had no idea that it was illegal. Essentially what Panther would do is post small bids or offers, and put large orders on the same side of the market to create the illusion that there is interest on one side of the market that wasn't really there. So here is what they might do:

If an August gold future (just as an example we'll use gold) was 1350 bid at 1350.1 (a tic wide), the algo that Panther used might post 2 lots on the bid. Then, after getting filled at 1350, they would show bids for 50 lots at 1349.7 and 100 lots at 1349.6 (3 and 4 tics below where they bought). This creates the illusion that there is buying interest in the market. In theory, showing these bids might lead other traders to become less aggressive from the sell side, which in turn would increase the likelihood of the market going higher. If the market goes higher, then Panther could sell out the 2 lots that they bought and have thus made a profit. They would then cancel the "fake" bids at 1349.7 and 1349.6. Outside the entrance to the exchange floor at the NYMEX building, there are posts of the fines and penalties, and why they were assessed. The documentation cites that Panther canceled about 98% of its trades that it posted, which is cause enough to believe that orders were being entered without the intention of actually trading. Without running the risk of incorrectly stating the regulator's contention about the violation, I will say that the argument appears to be that this feigning of interest is a form of market manipulation.

What makes this fine so interesting to me is the timing, and the nature of it. Recently, the aforementioned board outside the exchange floor (where fines/ reasons for fines are publicly posted) has been filled up with papers describing the violations people are committing. It would hardly seem to me that this is due to an increase in violations, so much as an increase in regulator scrutiny. What is disturbing and frustrating is that this kind of scrutiny seems to pale in comparison to the real issues (such as large players who have access to customer information that the public is not privy to). While practices such as the ones Panther was employing can be disruptive to the natural flow of markets, I would liken them to misdemeanors compared to the felony-like characteristics of insider trading. Imagine you were to hear about a hedge fund manager who got word of a surprise earnings beat that would not become public information until later that afternoon. Anybody would say that were the manager to use this information to put on trades before the earnings release, it would be a moral and legal breech of the highest order. If, however, you heard that a hedge fund manager put bids that he never intended to trade into the order book after buying a stock (to create the appearance of demand in the market) you probably wouldn’t put him on the same plane as the manager who traded on inside information.

In the above example, I used stocks. The spirit of market principles should apply to all asset classes however. When we are talking about gold, oil, or natural gas, there are no earnings; they are just commodities. But whether it is earnings, or information about demand for aluminum that is unavailable to the public, it is the non-public aspect (not earnings vs. supply/demand) of the information that makes it immoral; but at this point, not illegal. While we have seen more fines, and in the case of Panther, a very serious settlement, we cannot rest assured that the integrity of fair markets is being upheld. Coming down on the likes of Panther makes sense since they are in the violation of the law, but they are small issues relative to the inequity that exists between market participants.

         

Gold Update

It has been a long time since I've written about gold and the gold options market. I transitioned a few months back from trading gold to cotton options. Cotton has been flying higher in the last few weeks which has led to some exciting trading. I did not however give up on paying attention to, nor did I stop talking to people about the gold market. While I would not go so far as to say the gold market is exciting right now, there is a lot going on in the macro sense for all market participants to be considering.

I will start with a brief vignette that I think tells the story about what gold has become. In the mornings, I hand out technical charts to some of our traders. I handed my friend, who trades gold, three technical sheets; a chart with analysis for gold, silver and the S &P. He had been away for a week, so I figured he'd be curious to see how the technical picture had changed. But I noticed, that he passed over the gold sheet and went right to looking at the chart and targets for the S&P. I started laughing and asked him if he realized what he had just done. We had a good old fashioned nerdy laugh together, because we found it rather amusing that a gold options (volatility) trader was more curious about the stock market price action than he was that of gold. "It's funny, but this is what matters more" he said.

          

Intuitively, I don't see a tremendously strong correlation between gold and the stock market in terms of price. It is true that while the stock market (the Dow has, and the S&P probably will soon) is making all time highs gold has been drifting lower. So while the two have diverged on the longer term chart, one's daily performance is not predictive of the other's. A big up day for the stock market doesn't necessarily mean bad things for gold, and vice versa. Thus, my friend was not looking at the S&P chart to try to determine gold's direction, but rather the likely volatility implications.

The implied volatility in the stock market is largely a function of the stock market's direction. Investors are generally long stocks, so their risk is to the downside. As such, investors will buy puts as a way to protect that downside. When the market drifts higher, and things seem relatively calm, the demand to pay up for puts goes down. Writing covered calls (selling call options against the stock you are long) is also an attractive strategy for investors who are looking for income in their portfolios. Covered call writers (sellers)collect premium from the options they sell while foregoing upside on the stock they own above the strike of the option they sell.  Both widespread lack of interest in put buying and widespread interest in selling calls creates a situation where the demand for options is low, and the desire to sell them is high. High supply, and low demand equals lower prices. Lower options prices, is another way of saying we are in an environment of low implied volatility.

It is not hard to understand how we ended up here. With a government policy that has been pro accommodative policy (QE, "extended period of low interest rate" language) investors can justifiably feel that there is an implicit floor in the market. For even if markets fall off, we have all been given reason to believe that government will step in to keep stock prices higher. This helps to explain the lack of interest in wasting our precious dollars on buying downside protection. As for the selling of calls; we live in an environment of low interest rates. Income starved investors need a place to go for yield, and that place definitely isn't the bond market. It is why a friend of mine, to my mind, accurately pointed out that the structured products business  should remain robust as long as people cannot find good alternatives to collect income in their portfolios. So the environment is ripe for call selling and "not put buying". So how does this effect gold options and why are the two correlated?

Admittedly, I don't have a good theory from a fundamental perspective as to why this correlation between gold and equity option pricing exists. From a trading perspective, noticing and understanding how these patterns behave is generally more important than justifying why the pattern is what it is. One could look to open interest as a good starting point for understanding the change in volatility. While February open interest in COMEX gold futures is down 6% compared to last year, CME S&P e-mini open interest is up  nearly 12 %; so that would not seem to tell us much (http://www.cmegroup.com/wrappedpages/web_monthly_report/Web_OI_Report_CMEG.pdf).

You could also consider that GLD (gold ETF) has grown so vastly in popularity that gold has almost become more of an equity than it has a commodity in terms of its options behavior. In other words, investors who use the GLD  would have similar motives from an options perspective as a stock market investor would. I believe that would be an incorrect conclusion however, because however true or untrue it may be,  many investors still consider gold to be a hedge against their portfolio. As such, to hedge GLD holdings in a portfolio, would be hedging a hedge, which makes no logical sense. Perhaps gold is traded as if it is a currency now, and currencies generally trade at much lower levels of volatility than traditional commodities. But whatever the reason might be in intellectual circles, I believe there is a market based reason that explains why volatility remains low in these markets.

My same friend who looked at the S&P technical sheet first, pointed out to me that there are programs that look to buy and sell gold at certain levels throughout the day. They represent a large enough portion of the market that their sales can push the market lower on a short term basis, and their buys can push the market higher. Who would do this, and what is the point?

With volatility at these levels, it takes a lot less movement to break even on owning an option than it has in the past. If you own 100 at the money calls in gold that expire in about a month and a half; and you sold 50 futures to hedge out the directional risk of your position, you could move less than 12 dollars daily to break even on your options. This breakeven analysis is simply a way of understanding the amount of movement you would need to hedge the gamma from your options to cover the options' daily erosion. This might seem extremely low, but we do not move 12 dollars (open to close) enough to make buying at the money options and hedging at the end of the day an obviously profitable strategy. However, that does not mean that owning these options cannot be profitable; it is simply a function of when you chose to do your hedging.

In a market like cotton, if you are long gamma (long options, such that you get longer delta when you go higher and shorter delta when the market goes lower) it is generally unadvisable to hedge that gamma aggressively throughout the day. Too often the market will continue to trend in one direction throughout the day to make actively hedging an attractive strategy. You are often better off waiting until the end of the day to hedge your delta. In gold however, it is a different story. In the last week for instance, while the market would move, it seemed to find a way back to unchanged by the end of the day. At unchanged, you have no deltas to hedge from your gamma, and owning at the money options is a losing game (you lose your erosion every day). But that doesn't mean owning gamma is unprofitable if you know what you are doing.

Presumably, whoever has these gamma hedging programs, has some money behind them (enough to put on the risk, and probably to pay a few quants who have figured out optimal hedging levels/ size relative to their gamma given market conditions). I'm sure we'll hear about these guys in a few years; the technical traders who were smart enough to come up with a way to play the technicals in short ranges through the use of front month at the money options with well studied hedging strategies. The game might not work as well in a high volatility environment because from a risk perspective, there would be greater erosion per option and greater moves required for making breakeven. The other reason the active hedging strategy is a lower risk proposition in this environment, is that while volatility can always come in more, it is already at relatively depressed levels. Thus, if there is to be an extreme move in volatility, it is probably higher (and you are long vol when long options, so tail risk is favorable in this trade).

 I hope that the discussion of the above mentioned trade shows the impact that volatility can have on markets direction. As I point out, this strategy might not be so effective, and would be a lot more risky in a high volatility environment. So, when we are talking about the likely direction of gold from here, whatever side you might choose, be aware that it probably won't happen too quickly. At a time where banks are raising their S&P targets (Credit Suisse just raised their target to 1640) it might just make more sense to have money in the stock market. That being said, if you are looking to get into the gold market here, there is a very clear stop that you can use around 1525. I was speaking with a broker whose eyes lit up last week when I brought up gold's last test of 1525. The time was more volatile, and the algos tried to knock it down through that level, but failed as an order of about 6000 lots scooped all of the offers. It was by far the biggest defense of a level I have seen over the course of the last couple years.  So on the longer term chart, this should be a very supportive level. If you want to get long gold here, (1590) then you have 65 dollars of downside until your stop out (somewhere just below 1525). So from a risk perspective, you only have to risk about 4% to the downside. If you look at a 3 year chart of GLD, you will see that the 150 level approximates where 1525 is in the futures. As you will see, this level has been tested multiple times and held since it was first eclipsed in 2011.

While it has been a while since I've written, I hope that this provided a few insights and thoughts that you find valuable or at least worthy of pondering. If you have any questions about the ideas I have, or want to flush them out further, please don't hesitate to send me an email at BenjaminMRyan@gmail.com.

All the best,

Ben