The Liquidity Illusion

“Tighter markets will lead to more liquidity and more efficient markets”.

Maybe, but so what?

At any given moment you can look at the options boards for most of these options and get a tight quote, probably much tighter than you would 5 years ago. While that is nice, it is not clear that it does a great service for the “efficiency” of markets. While the market is tight, it is prone to change more drastically, more quickly as a result of lower volume.

Take for instance what has gone on in gold options in the last week. Call skew (the difference in volatility that a call option is priced at vs the at the money vol) is the highest I have ever seen. That includes the call skew when gold made all time highs at 1900.  The degree of movement in call skew, on a mere move to 1150 on October options expiration took all of us by surprise. While it might signal some short term bullish sentiment, it is being priced as if gold is going to 1300 some time soon. That seems a bit optimistic as 1220 should serve as strong resistance on the longer term.

As an options trader, it is important to keep a close eye on size options orders as they may be indicative of a shift in sentiment. My view so far is that while rallies to the 1220-1230 level are not out of the cards, moves above that will require a complete shift in sentiment toward gold. At that point, we might see the beginning of a major bull market. But we are not there yet. 

In the ~ 3 year daily chart above, you can see that gold is still in the middle of the longer term slow moving downtrend. The significance of this 1220-30 area (and perhaps up to 1250 depending how you draw the downtrend line) is that a breach of it would indicate a break of this long term down trend. 

If we use the chart as our guide, we can certainly see that bulls might have a decent reason to get bullish. But it is not the most bullish setup anyone has ever seen.  You can see the challenge in predicting the change in skew in calls in gold. We are in the middle of the range, so we cannot get aggressive with our calls either way. If that is our attitude (rather neutral on market direction) then we certainly wouldn't expect call skew to blow out like this. We always need to pay attention to orders, because they could be an indicator of things to come.... but there could be other reasons for this massive move in call skew on a historical basis.

Liquidity.

The locals, options traders who historically traded their own books, are dying like flies, but have not adjusted their mentality to the new realities of the market. I am one of these unfortunate souls. In an effort to be optimistic we remind ourselves of how much money we can make when things go awry. But this time IS different. While we have always been the less capitalized on an individual basis, we are more commonly becoming less capitalized as a group. The advice and thoughts I have given this site and my close friends has been net profitable over time. But that doesn’t mean that those who listen to what I have to say, or even that listening to my own good advice will remain profitable.

Options prices are dictated by 2 things. The performance of options, and the price people are willing to pay, or sell options at. This site has made the point that volatility is underpriced in the gold market, and has been over a 2-3 month time frame for the last few years. How then could a trader who is long options lose in this market?

LOCALS, aka THOSE WHO VIEW THEIR JOB AS GETTING PAID TO TAKE THE OTHER SIDE OF A TRADE, ARE AT THE MERCY OF THOSE WHO HAVE THE REAL MONEY.

While I feel very fortunate to have a backer who will risk his personal capital on my investment decisions within the COMEX gold market, I cannot pretend to be more impressive than I am. Because we are small, my future is highly dependent on the big players’ willingness to put on trades that reflect the nature of the market, not its liquidity.

I do not expect the readers of this blog to do research on options pricing and how it resembles future pricing. It takes a lot of time to understand this market, and once you think you do, you will often find yourself disappointed.

As such, I’m forced to repeat the same thing I’ve been saying for some time. YOU CAN WAIT FOR BETTER OPPORTUNITIES.

It has been a while since I have written about the gold market. Here is what has happened since I last wrote.

My partner Georgi and I have been completely on top of price action. We have been so right that my close friend, who had been asking about our outlook, thanked us for putting him into so many good trades.

This is not a self-congratulatory comment. I have had my worst performance on an options trading basis since I got my own book two years ago. I have been more on point with respect to price movement than I have been in my career, and I’ve lost more money in that period than I ever had over a similar time period.

How to reconcile such a situation? On some level I feel like a genious; but my P/L makes me feel like an idiot.

While I wish I had made what I would expect given my options positions over the last month, I have felt this strange sense of optimism. I have realized that my current business model is less effective than it was two years ago. I realize the market has changed. I only write about it because I hope my readership (however small) might gain some perspective from my experience.

Money moves markets. Retail, small companies, and individual traders have a relatively small amount of money. While we might be right in calling ourselves “sophisticated” we are still relatively poor. Locals like myself historically profited from their understanding that curves would come back into line over time. If a fund came in and paid for an April 1250 call, selling it and buying a front month 1200 call would be profitable in the course of a day or 2. In the current market environment, the person who put this trade on might find themselves surprised by the profits that are NOT flowing into their account in the short term.

In the current environment, it might take a month to recognize the same profit. If a local is poorly capitalized relative to the initiator of the trade, they might be forced to puke out of their trade before recognizing the profit they would historically come to expect.

Welcome to the new market.

There are fewer participants available to take the other side of real orders. When a trade goes against the locals, they have to take their trades off too soon. Bottom line? Being poorly capitalized relative to the major players in a market makes for big challenges ahead. This was probably always true, but now, the money that could be made trading throughout the duration of such a trade is less than it has been historically. As such, less capitalized players, with backers who need to justify their own investment in their traders, are in a challenging place. Being right is not a precursor to making money. Options prices are more often controlled by the supply demand of the market, and as the “local” becomes more obsolete due to their capital constraints, accurate assessment of price movements have a smaller impact on the profits one can expect.

The conversation as it started was focused on the idea that it is dangerous to invest in options when the volatility of those options can be so drastically impacted by the supply/ demand concerns of the market. This is the take-away that I hope all readers remember. I have been right at an all time high rate, and profitable at an all time low. It is not because I have put on a bad position. As mentioned, such a position historically was the desire of all traders. As I watched myself be correct, I watched the losses pile up. It was a sobering lesson that the people with capital, and their choices about which part of the curve to invest in, are more important than my own opinions about the market, even if my expectation are fulfilled at an impressive rate.

Readers. Please, do what any self loving person would do. Look out for yourself. Don’t get too heavily involved in markets when being right doesn’t mean being profitable. We constantly make bets on things that have happened historically, but have no fundamental reason for happening again. Don’t bet on the latter. Patience is best for this (and probably all other markets) market. While liquidity, or the lack thereof, despite “tight markets”, is a great reason to fool us into believing we can be profitable on a basic understanding of the market….we have to be smarter. I am a firm believer that the investor who makes fewer bets, and only when they have strong reasons for making such bets, will be successful going forward.

If there is one take-away from this, please let it be that being right is not the same thing as being profitable. I have a million things I could write about with respect to gold, but it is not worth writing. It is simply not an asset class that any investor has a great reason to go either long or short. Let us wait until that changes, and we can discuss why. Until then, remember; you are never in a rush to take a stance, and if you feel rushed, it is best to step away until such urges go away.

All the best,

Ben Ryan