Executive summary

In this issue, Rich focuses on the metal markets and reviews two option strategies that are extremely relevant due to recent global events.

  • Using put strategy to hedge systematic risk.
  • Employing technical analysis to identify opportunities in the Silver market.

Over the course of this year, we have attempted to navigate the choppy waters of the world by exploring different options ideas to tactically invest or hedge in assets such as cryptocurrencies, interest rates, equity indices, interest rates and agricultural products. Over the next few weeks, we will go back to my roots in the business. I started my career trading FX options on the CME Group floor. After moving to the OTC world I added precious metal options to my toolkit. Thus, these products are near and dear to my heart and I always keep an eye on the happenings there. This week, I want to focus on the metals complex.

There are so many headlines, events and news items affecting the markets this year. As I tell my students, Finance can always be broken down into cash flows and discount rates. With the global events we are witnessing, economic growth throughout the world will certainly be the main driver of cash flows. With the FOMC meeting last week, we got the latest update on what discount rates we will be applying to those cash flows. So where do we go from here?

One of the relationships that has always been particularly interesting has been the relative performance of Copper to Gold. For intuitive reasons, Copper outperforms Gold when the economy is strong because there are more economic uses for Copper – traditionally housing, but also medical equipment and now electric vehicles. We can observe this relative performance and when it disconnects from economic expectations, there might be a trade opportunity. Even when the latest moves are in line, but where the forecasts may be grim, there can also be trades to consider. 

Let’s consider the first graph (Figure 1), which plots in blue the ISM Purchasing Managers index vs. this relative relationship of Copper to Gold. Many notable bond fund managers have said this is the main relationship they watch to get a gauge on where the economy, and therefore the bond yield, is going. As you can see in the picture, sometimes the relationship leads the economy (e.g., 2012-2014), and sometimes the economy leads (2016 or 2020).  Currently, the economy is still sitting at a healthy 58.6 level; however, a growing narrative is concerned about the potential for a recession (ISM below 50) led by the rapid rise in food and energy prices. If this is the case, there is potential for downside in both lines. Of course, nothing is for certain, but let’s assume this is your view.

Figure 1: Copper/Gold relationship to ISM Purchasing Managers Index

Using the QuikStrike platform, we can look at the Commitment of Traders reports to see how the various players in the Copper market are positioning for moves ahead. While the positions have been relatively stable this year, there has been a slowly growing short position among the producers, while the managed accounts have taken the other side. The end users are hedging more aggressively, perhaps with some concern of an economic slowdown and lower prices ahead. Copper is known to be the commodity with the PhD in economics, after all. Copper has also benefitted from the inflow of funds into all commodities via systematic strategies and ETFs, even though the supply/demand outlook may not have changed as much as in products such as aluminum/nickel or oil/natural gas. Thus, we can start to see why there may be economic rationale for lower relative Copper prices ahead, and we may be seeing some of this flow coming via the producers in the COT report.

Figure 2: Copper Commitment of Traders report

Turning to the volatility markets, one can look at the CME Group Volatility Indexes (CVOL) to get an idea of where the relative implied volatility levels are for both Copper and Gold. Implied volatility is elevated, for all asset classes really, relative to a year ago. However, when we look at current levels vs. the three-month range, we can see that Gold volatilities are actually more elevated within its range than Copper. Yes, Copper is slightly higher in absolute terms than Gold, but comparing each relative to its own history, Copper may be seen as relatively more attractive.

Figure 3: CVOL Copper and Gold

Pulling this all together, if one is getting worried about a potential economic downturn, there may be the need to hedge against this outcome or to tactically benefit from this view. In a market where all implied volatilities are relatively high, it is often more palatable to do spreads which entails selling some options you deem to be more expensive or less likely to end up in the money, to use those proceeds to buy options that may have a higher probability of winding up in the money. This idea can be riskier than simply spending premium for an option idea. However, it can also generate a higher return if the trader is correct.

For example, consider selling a Gold June 1875 put and using the proceeds to buy a Copper June 440 put. Based on the prices in Figure 4, this trade is essentially premium neutral. The ratio of the strikes (440/1875) is 0.2347, which is exactly where that relative price chart vs. the ISM is above. If there is more relative downside in Copper than Gold, the long Copper puts could potentially finish deeper in the money than the short Gold puts. This may happen if there is an economic downturn. If both products move higher in the event of money broadly flowing into the metals complex – since the relative idea is roughly premium neutral – there is little to be lost. The major risk is if there is downside in Gold but not in Copper. This is possible, particularly in a world where we see a positive conclusion to world risks and the economy picks back up. That is for the trader to decide.

Figure 4: Copper 440 Put (on left) and Gold 1875 Put (on right)

Staying focused on the metals complex, I want to look at an example purely from a technical standpoint. I haven’t looked much at the charts so far this year, but there is a chart developing in Silver that looks particularly interesting from a technical standpoint. As you can see in Figure 5, there has been horizontal support in and around the 22 level. On the upside, we are seeing a series of lower highs. Those who look at technical analysis will see this as a descending triangle pattern. If this pattern breaks to the upside through the red line I have drawn, the measured move suggests the futures contract move to 33 because the height of the triangle at the beginning of the pattern is 8 and you would add that to the level where it broke out. In the last few days, it has attempted to breakout but has been rejected. If this move is rejected, and the downside does not hold, there could be a risk for a move back to the 15-17 level. Given we are currently at 25 in the futures, there is a wide range of potential outcomes if this pattern breaks. The more the pattern narrows, the higher the odds of one side of the pattern ultimately giving way.

Figure 5: Silver futures

Let’s say a prop trader is looking at this pattern and thinking about what they could do. They could wait for the pattern to break out or break down and put on a futures trade. They may be competing with many others to do the same. What other ideas could they consider? When I look at patterns that could move in either direction, my instinct is to look at straddles.  Perhaps bigger moves could be priced in, but if those moves are not priced in, there could be opportunity.  Using the QuikVol 2.0 tool, one can compare the implied volatility (what traders think will happen in the future) to the historical volatility (what has happened in the recent past). This gives a measure of the insurance premium one is paying to buy options. If the IV > HV, one is paying a premium to what actually happened because traders think there will be bigger moves ahead. If HV > IV, the expectation is for less volatility and not more. Looking at the graph below (Figure 6) HV > IV, so less volatility, not more, may be expected.

Figure 6: QuikVol Silver

Using the QuikStrike’s ATM Vol Term Structure tool,  April is the lowest implied volatility, but it is also expiring relatively soon.  May looks like the next best value, while June is at a premium to the dates around it. The May expiration may be the best place to look.

Figure 7: Silver ATM Vol Term Structure

Looking at the price and the breakeven of a May 25 strike straddle:  one can see from the Spreadbuilder tool, this straddle costs a little more than 2 for the May expiration.

Figure 8: Silver straddle

The expected return chart in the same tool shows us our breakeven on this trade. As constructed, it would be 22.77 and 27.22 (interesting symmetry). On the one hand, this might seem like quite a move to expect to happen. However, if we think back to the descending triangle pattern, the downside breakeven is essentially at the horizontal support, which if it breaks could lead to large moves lower. The upside breakeven is above the descending trendline. Should we break that 25 level convincingly, the measure move would be to 33. I like to look at these straddle trades at an inflection in the market to play a move in either direction. Owning straddles, though, can be an instant gratification trade. The risk is the time decay paid if nothing happens. The discipline on this idea would be if nothing happens in the next couple of weeks, it may be time to limit losses, sell the position, and move on. While one can never forecast in which direction a chart pattern may break, one might be able to get better results by expecting a big move in either direction.

Figure 9: Silver straddle expected return

I do understand that these examples may not be for everyone. The idea of spreading one product vs. another product may appear to be too risky for a trader’s risk limits. However, there is an economic intuition and an empirical logic for why the relationship could hold, and in a market of higher volatility, selling options on one product to fund the options on another can result in much better return potential. Similarly, in a product which may be poised for a bigger technical move (though we may not be able to tell in which way), the straddle could be a good example of how to position for a break.

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