Introduction to Gold Volatility Trading

  • 15 Mar 2018
  • By CME Group
  • Topics: Metals

Why Commodity Volatility Trading?

The first natural question that comes to the trading community is, “What are the compelling economic fundamentals behind commodity volatility?” Volatility is measured by the fluctuations in price that are derived from new information flowing into the market. For commodities like gold, this could be an inflation report, an economic disruption, or a mining strike. Sometimes, of course, it is the lack of information or uncertainty about demand and supply that causes prices to change dramatically.

For example, a political crisis where there is an uncertain outcome. The resulting magnitude of price changes induce risk into commercial or investor positions. Consequently, the extraordinary price movements in both financial and commodity markets in recent decades has compelled the trading community to look to not only the impact of volatility on a particular asset class, but also to how volatility spills across asset classes.

Gold Price and Volatility

The last twenty-five years has witnessed a surge in financial market volatility. The reasons are too numerous to list separately here, but among the most important are increased globalization and the trend toward economic integration, the rise in emerging market economies, the increase in the number of market driven economies, technological advances in trading, and increased use of hedging instruments. The increased level of market uncertainty has led market participants to think of volatility as an asset class in itself.

Applications

 

It is of course incumbent on the trading community to not just understand the impact of new information on prices, but also to apply it to their trading positions in a rational way. Specifically, the question must be answered,” What is the proper role of volatility trading, particularly for asset classes like commodities?” For the trading community, “what would volatility trading add to an investor or trader’s portfolio?”. To answer this crucial question, the interested trader needs to understand the economic significance of volatility. The relationship between volatility and information (or lack of) on other assets is directly related to the role of volatility as a portfolio diversifier.

As an example, volatility in gold prices can have important implications for equity, fixed income, and currency markets. As a rule, Gold can be thought of as currency proxy. Fluctuations in price imply a reassessment of the risk of inflation, deflation, or currency fluctuations. Volatility, as represented by the magnitude of these fluctuations would then reveal information on currency and inflation developments that would be important for other markets like stocks and bonds.

It is well documented in the equities markets, that volatility tends to have a negative correlation with price, i.e. market downturns tend to coincide with high volatility. This is a peculiarity of equities as equity value provides a cushion for debt levels of corporations. As that cushion deteriorates during a stock market downturn, it becomes self-reinforcing by raising doubts about creditworthiness. This in turn leads to more stock market selling and increased volatility. It is for this reason that the VIX volatility has been called the “Fear Index”.

 

 

The pattern of behavior in the gold market is different. In many ways, gold can be thought of as a safe-haven from economic and political turbulence. Gold prices rise typically when inflation rises, currencies (especially the U.S. Dollar) become weak, or world events go awry. Consequently, gold volatility has a much more mixed relationship with price than does the stock market. There are times price and volatility rise in tandem. The 2008-2009 financial crisis is a good example of that. Economic weakness in the U.S. led the Dollar to fall and inflation expectations to rise. Thus, gold price and volatility both rose. The acute European banking crisis in the summer and fall of 2011 had a different result. As Europe descended into economic crisis, the U.S. Dollar rallied and gold prices fell, even as volatility rose. Volatility trading for gold, unlike stocks then, can be unrelated to price levels.

There also tends to be spillover effects for different asset classes in terms of volatility. Prices, whether those of financial assets such as stocks or real assets such as gold, react to new economic information. For example, news on overall inflation tend to lead to changes in both the price movements for wheat and gold, even though the resulting price swings may be of a different direction or magnitude. The reasons are twofold. First, new economic information is likely to touch all markets in some way, leading markets to reassess price. Secondly, this information is likely to cause the trading community to rebalance positions due to gains and losses in their portfolios which would lead to cross asset correlation based on volatility, if not on price.

 

Volatility Trading Strategies

The financial markets have a long history in trading volatility. There are many options strategies that are based on the differences between expected and realized volatility. Option “straddles” (buying both a put and call option at the same strike price and same expiration) being the most prominent. In this case, if volatility were to cause the market to move higher, the call option would move in-the-money. If the market were to fall sharply, the put option would be in-the-money.

There are other strategies to trade volatility. Option “strangles”, are similar to straddles in that they involve both a call and put position. However, the strike price of the call tends to be higher than the strike price of the put option. This position tends to be less expensive but requires an even greater move in underlying prices in either direction to profit. There is also a “butterfly” strategy which requires buying an out-of-the-money call (or put) and an in-the-money call (or put), while simultaneously selling two calls (or puts) in between. In this case, it profits with less extreme movements in the market. Each of these options strategies involves fluctuations in the direction of price changes as well as changes in volatility itself as part of their payoff. In general, options volatility strategies need to be periodically rebalanced in order a pure view on volatility.

Summary

Volatility in gold, as well as volatility trading has become an important feature of the financial markets. It is argued that it has become an asset class in its own right. Gold volatility has become a key measure for gauging as well as weathering the recurring turmoil in the world economy as well as the financial markets in recent years. As such, it has become an important tool for hedging systemic risk and uncertainty. The value of such a hedging instrument of course is dependent upon its correlation with the rest of the portfolio. Gold volatility has demonstrated in recent years that it has become an important means of financial diversification. These diversification properties are enhanced further as they are shown to be leading indicators.

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