Wednesday, November 26, 2008

Recent Gold Volatility

I have been receiving quite a few questions about gold and gold volatility lately, so with gold receiving a lot of attention in the press, I thought this would be a good time to check in on the commodity and on the CBOE’s gold volatility index (GVZ), which was launched back in August.

Gold is something every investor should be watching these days as it reflects the ebb and flow of opinions about the risk of deflation in the short run and inflation over the longer run.

In the chart below, I have captured the price action in the commodity as tracked by GLD, the popular gold bullion ETF. I have also included the GVZ (aka “Gold VIX”) to gauge some of the recent volatility in gold trading. Gold volatility peaked back on October 10th and has been in a gradual downtrend for the past six weeks. The chart reflects that spikes in gold volatility have generally coincided with spikes in the price of the commodity.

The broader issue of correlations between gold prices and volatility is much more complicated and subject to cyclical swings. In the chart I have highlighted two periods in which gold and gold volatility have shown a persistent negative correlation, first in August and later in mid-October. These two instances were both bearish for gold prices, yet when the correlation switched back to a positive one, gold prices began to move up in both instances.

It is still too early to draw any definitive conclusions between gold prices and gold volatility, but I will return to this subject periodically as my thinking evolves on the subject.

[source: VIX and More]


Eric said...

I was wondering if you could weigh in on the following leveraged strategy that takes advantage of volatility.
If I were to buy equally weighted portions of Bullish/Bearish ETFs on Gold (or anything else for that matter) and sell far OTM covered calls against them, what is my downside? The way I see it, I should net out to zero on the core ETF positions while collecting the option premiums.
Can you poke holes in this? Look at FAS, FAZ. By my calculations, I can grab 10% premium for a 100% OTM Covered Call on FAZ, and 3% on the 100% OTM FAS calls.

Bill Luby said...

Great question -- and an interesting trade. This type of trade has some characteristics of a condor trade.

I did some quick back of the envelope calculations that assumes FAS at 26.24, the Dec 30 calls at 3.60-4.50 (assume 4.00) and FAZ at 68.80, with the Dec 70 calls at 16.70-18.60 (assume 17.60) [alternatively the Dec 75s are at 15.30-17.20].

A ratio of the prices is about 8:3, so let's say you buy 800 FAS and 300 FAZ for approx $41,632. You sell 8 and 3 of the Dec calls and that nets about $8,210.

If the ETFs stay put, of course you clean up to the tune of about $8,200. What happens, however, if the financials move sharply one way or the other? Remember that a 33% move means the ETFs could double, a not unthinkable scenario.

So...if FAS doubles and FAZ loses 50%, some back of the envelope calculations says the ETFs net about $10,700, but the calls are now about a $14,000 larger you are out about $3,300.

The opposite scenario involves FAZ doubling while FAS loses 50%. In that one, I have the ETFs gaining about $10,100 while the covered call liability grows by about $15,000...for a loss of about $4,900.

Balance these numbers against a possible $8,200 gain from the covered calls if both expire worthless and that gives you a sense of some of the risk/reward characteristics.

I'll put one of these Direxion ETFs into an iron condor trade on the blog for fun in the next few days. It should look similar to what you have proposed.



Lawrence said...

the diversion between gold etf and the vix index could be due to strong market/gold manipulation during those periods. It would be intresting to see also some major stock indices superposed also on the graph.

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