Saturday, 26 April 2014

Gold - A better way to go long? (Part 1 - Basic Scouting)

I'm sure many of you have been thinking about going long gold given the recent crisis in Ukraine. In general, gold is a safe haven investment. Traditionally when there's been war or uncertainty in the market, money flows into gold. However, gold is also hurt by a stronger US dollar (since Gold is priced in USD) and rising interest rates (since Gold pays no interest). So in today's complex markets is there a safer way to going long gold than simply buying GLD shares, long gold futures or picking up some physicals? Let's take a look at the options market and some important statistics! 

Friday (4/25/14) Closing Price

We can see the implied volatility (IV) of GLD for the next 30 days is 14.62% (annualized) as of 4/25/14 close. What does this actually mean? Since I use Livevol Securities as my broker, they provide the software. Here is the official definition:

IV30™: A proprietary measure of the volatility of the hypothetical 30-day (calendar days) option. It's a weighted average of two months and several strikes used to compute a vol index for each stock much like the VIX does for the entire S&P 500. 

Stated simply, it basically means the option market is saying GLD has a 68% chance of ending up between $120.17 and $130.69 within 30 days. How did I come up with those numbers?

Standard deviation calculation: 
price x volatility / Sqrt number of timeframes in 1 year = 1 Stdev 

so 125.43 * 0.1462 / sqrt(365/30) = 5.26 (2 significant digits) 

If you add and subtract 5.26 from 125.36 you will get the range $120.17 and $130.69.

Of course, to make things simpler you can always use a very handy online calculator

It's very important to understand IV, it is a critical component of my trading decision. IV is one measure of the risk priced by the market! This trading range is not what I think, not what hedge fund manager XYZ thinks, not what Gold Guru bob thinks! It is the risk premium priced into options by the actions of traders buying and selling GLD options! IV is always changing, market makers tend to increase the IV when there's alot of buying at a certain strike and lower it if there's alot of selling.

If you think GLD will trade inside this range of 120.17 and 130.69, then the volatility is over priced for you. For example, you can express this view by selling an ATM straddle or strangle.

If you think GLD will trade outside the range, then volatility is too cheap, and you can express this view by buying a straddle or strangle. 

Now let's take a look at IV in context of a year. It's definitely in the lower range. It's only ranked in the 7th percentile on a 52 week basis. Now you may think this is underpriced volatility but take a look at the HV30 (this is the actual volatility of GLD in the past 30 days annualized), and as we can see it's just 12.13%, which is actually lower than the current implied. Of course, the past is not indicative of the future but it can be a good gauge into the relative "value" of the IV (as long as there hasn't been some kind of event in the past 30 days which may distort the HV, such as earnings or some kind of important announcement). 

In general, you want to buy underpriced/fairly priced options and sell overpriced options. Based on the HV30 and price action of GLD in the past 30 days, it seems the options are not overpriced at the current IV30. This doesn't mean they are under priced either, since GLD may not move at all in the next 30 days, in that case the IV30 will be actually overpriced today. 

The next component we can look at is the net delta. 

Net delta: The overall delta position accumulated by market takers (customers) through options only for trades on the bid or offer; i.e. people getting long or short delta through options.

Examples below:

Okay, so from the first scan of GLD stats, we can come to 2 conclusions.

a) the IV is fairly priced (at least compared to the HV30). so we won't be at a severe disadvantage buying or selling options.

b) the market on Friday is net long deltas, so our view of going long is confirmed by actual trades. Of course it was a strong up day for GLD but at least we know the money flowing into long delta positions is alot more than short delta positions. 

In the part 2 we will start structuring a trading position!  

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