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
