Selling Options Premium in Gold (GLD)

Gold has been a hot topic of discussion among investors & traders lately, supported by media frenzy over how gold as an asset class has done this year . We all have our thoughts on why gold prices tanked and continue to opine on how gold will perform moving forward . Increased volatility in gold prices stretched options premiums as option markets priced in sharp downside moves in gold even though gold is not moving at levels seen during April this year . For those who like to trade options in Gold, you have to put into context how gold has moved historically , how are options currently priced  and take advantage of opportunities which exist.

For an options trader it is extremely critical to have an opinion on direction of volatility in addition to the price of underlying. Chart  displays the realized volatility in gold over a 30 day period for the last  4 years. 30 day realized (historical) volatility currently stands at 16.0%  and it has ranged between 7.5% to 37 % putting it in 50 th percentile.

Let's see how Implied volatility levels are priced across the tenor and what I expect  values of implied vol should be.  We can see front month options are priced fairly and second month ( IV60) options are  priced cheaper than expected- this can be explained by holiday theta effect- as theta during holidays gets decayed out of option prices. What we lack into our current analysis  is our view point on realized volatility. We can clearly see it spiked up-to 36.8% level before it started its slow descent down.
Gold was down almost down by 9.5% on April 14 and since then has been only down by 6.5% . Speed at which gold moved subsided dramatically which is reflected through declining realized volatility levels. My take is gold's realized volatility will continue to decline and will hit single digit levels.This is supported by the fact that market is not expecting QE taper by March now in addition to declining inflation expectation in developed economies.

As I wrote in my previous post, I expect gold prices to continue tracking the price patterns gold exhibited during late 70's and early 80's - making me short term bearish on gold.  I expect gold prices to move down close to 120  with 116 as my limit and upside capped close to 131'ish level. With opinion on price and volatility in place - my inclination is to create a trade structure which is short delta, short gamma and short vega. Positive theta is  a compensation which I am getting paid for being short gamma.

Buying  Feb/March ATM or slightly OTM put calendars financed by Selling Feb Call credit spreads ( in a ratio) offers balanced greeks & good risk reward.   

Gold Analysis

Investors have always flocked to the safety of gold to prevent against inflation, systemic and liquidity risks in global economy.  But what do us as investors do when our safe haven has lost or in the process of losing its appeal as a safe haven.  For a long time investors have presented that gold closely tracks the movement in real interest rates. Here’s chart representing movement of gold prices and real interest rates since 1968.

Historical Perspective on Gold

Indeed we see  a silver line between gold prices and real interest rates – negative real rates cause gold prices to explode to upside . Inflationary shocks of 70’s, declining real rate from 1976 to 1979, caused strong upside move in gold prices which followed move in nominal rates as well. Federal Reserve pursued policies to break the back of inflation from 80’s causing real rates to spike up and gold on a path down. Real rates peaked in 1984 following dual mandate policy of Fed towards price stability and full employment.  

I kept asking myself despite all the economic theories in play why would equity markets rise in lock step with gold (which implies a rising inflation and declining margins for corporations in future) and interest rates.  Analyzing profit margins for American corporations seemed to offer an answer to my curiosity.

Charts above help us in putting the pieces together for solving the mystery of price action between gold, S&P500 & interest rates. We found correlation close to 86 % for S&P500 and Gold with corporate profits. Rising corporate profits imply aggregate demand in the economy & productivity improvements captured in economic growth. This growth leads to investment demand, credit growth and last but not the least  increasing investor expectations for future growth.  These expectations along with economic reality feed on itself – increasing  future inflation expectations & pushing gold prices higher.   Historically there have been periods where  interest rates, gold & equity markets have de-coupled from economic fundamentals, sliding into a state of irrational dis-equilibrium.

Economic fundamentals suggest  rising real interest rates even though indicative of growth can also cause a compression in return on capital for corporations unless the costs are passed on to consumers- which can itself depress the aggregate demand.

Corporate profits tend to peak out before S&P does which supports the diminishing return on capital for American corporations but investors treat it as an isolated event and various  theories are presented such as resiliency  & strength of economy and corporations.  I am a strong believer in resiliency and capability to innovate for American corporations but an investor can not overlook diminishing returns for the businesses. Additionally, as an investor you might not be able to precisely identify state and timing of disequilibrium in an economy but can identify the factors & their causative relationships to dis- equilibrium.    

Where do we stand now?

                We hear & read pretty much on an everyday basis that corporate profits as a percentage of GDP are at record high levels and are unsustainable moving forward. This leads to discussions related to bubbly state of equity markets which are supported by QE steroids, low interest rate etc.  Getting back to the basics - rising real interest rate till the point they de-couple from economic reality for whatever reasons- imply shifting dynamics for increased consumption growth, demand for investment in an economy. It remains to be seen and established if this economic growth leads to an improvement in household’s net worth (Even though Federal Reserve will strongly argue it has created wealth affect with unconventional monetary policies). Equity markets should move in lockstep with interest rates -similar to what we saw in late 70’s and early 80’s. Gold as an asset class has under-performed since Oct-2012 and will continue to do so until equity markets and interest rates de-couple.  We can argue gold has bottomed out but I would argue it hasn’t yet and still has room to fall. Recognizing historical pattern of similar price & momentum behavior sheds more insight into this analysis .Current price performance of gold is closely tracking the behavior exhibited by gold from early 1980’s.  Rising interest rate in current economic environment is more indicative of growth as opposed to tightening by monetary authorities.  This dynamic will keep S&P500 anchored to interest rates and low inflation expectations will maintain downward pressure on gold prices

From a technical perspective, Gold should find good support between $1050 and $1200 before it embarks on another rally. Bottom in Gold prices will be matched with a bottom in corporate profits and will most likely mark the top in S&P.  Identifying & differentiating the causative factors will help investors significantly in timing of this position. Few things which need to be watched out carefully

a)      Breakdown in Lockstep relationship between S&P500, 10 yr note, US Dollar

b)      Falling Corporate Profits as % of GDP

c)   Receding deflationary pressures and pick up in inflationary pressures beyond a certain threshold