Sunday, November 17, 2013

Trading Volatility Spread between S&P and Gold Options

There are only predominantly two main topics of discussion floating around financial markets these days- Are we in a bubble ( with S&P at its all time highs) and has the gold  bottomed out at these levels. Arguments can be made to the both sides for both asset classes, but we as traders have to deal with situations we are handed in present and exploit mis-pricing in market place to generate profits. 

I wrote few days back about what I believe drives gold prices from a macro perspective, and what we should be focusing on  moving forward.  If interested you can read the article by clicking the link below

As I dug deeper into analysis of gold and equity markets, one thing which struck me quiet interesting was the relationship between implied vol for both asset classes. Interestingly , implied vols for both have historically tracked each other very closely until this relationship got whacked in April this year. Gold volatility (normally  priced cheaper than S&P 500 )exploded to the upside due to sharp moves we saw in gold earlier this year. Currently spread between gold and S&P implied volatility is 5.57 points which is quiet high from a historical perspective. 

Red -30 day Gold Implied Volatility, Blue- 30 day SPX Implied Volatility
Based on realized volatility in both asset classes, I expect realized volatility in Gold to continue the declining trend and expect SPX realized vol to spike up in future. Having said that, this spread can also converge to historical levels with  volatility in gold declining lower than SPX. I want to create a trade structure which takes advantage of this convergence. 

Starting up with Gold,  below is my expectations of implied volatility 90 & 120 days out 

Expected IV 90 day :  18.3%   
Expected IV 120 day :  18.6%  

Using above stated numbers , I calculated  one standard deviation  of $8,  selected 133 & 115 as price levels  which gold prices should stay with in.  Instead of selling them naked and exposing the position to significant losses, I add hedges to both upside & down side- there by creating a structure similar to iron condors. ( Essentially short gamma, short vega,slightly short delta and positive theta)

Moving to SPX, my expectations of implied volatility 90 & 120 days out 

Expected IV 90 day :  14.6 %   
Expected IV 120 day :  15.0 %  

Presently  IV 90 & IV 120 for SPX is at 12.65 % & 13.57 % with budget talks and debt deal discussions scheduled to resurface back again in Feb , I expect IV for Feb & March to pick up significantly . Combine this with QE taper you should be strong upside move in volatility

Now putting some perspective of bubble talks we are faced with on a daily basis these days. Well, when every body is talking about a bubble - they last longer than everybody thinks. Secondly if everybody thinks equity markets are in bubble - one would expect smart participants to position themselves accordingly. There is no bidding up of Skew for SPX - which leads me to believe , this market will keep grinding higher until it doesn't. Supporting this bias of mine, I use a prop indicator which I had developed earlier to analyze current momentum of equity prices and understand where we stand 

Clearly it seems that we are not yet in ridiculously expensive state.  With this in mind, I want to create a trade structure which will let me enjoy the grind higher and offer me downside protection. In addition , I want to take advantage of theta decay from holidays. Based on  this, I used OTM Feb/March 182 calendars with March  173 puts in ratio. Position is essentially short delta, short gamma , long vega and slightly negative theta . 

How do you manage the risk for this trade. Risk for trade in gold is to the upside move in gold which based on my analysis will come from pick up in inflation  or drop in value of dollar. Both these factors are positive with S&P till the time they de-couple. If rise in gold is  due to liquidity risk in markets, we have sufficient downside protection in  S&P which will help.  Ability to ride the S&P's upside move limits our upside risk in gold. 

1 comment:

  1. Nice work with the blog. :) I'm going to address something that I have seen from time to time. What is your measure for "There is no bidding up of Skew for SPX?"