Executive summary

With current macroeconomic factors and several market catalysts approaching, traders may be looking at gold as a safe haven. In this issue, Rich takes the other side and considers a short gold call spread to fund a put. He also looks at delta-hedged copper calls as a strategy for the current economic environment.

It is one of those years that has investors of all asset classes worried. The trends have been clear and relentless all year, which is why we have seen good returns to momentum and trend-following and more difficult trends where there is a reliance on mean-reversion.

It didn’t get any easier for investors this past week when the FOMC decided to hike 75 bps in addition to keeping its pedal to the metal, suggesting terminal Fed Funds could go up even 25 bps higher than the market was already thinking. This led to a bearish reaction across asset classes.

Often, investors will wonder where there may be a safe haven for them in times like this. Gold has historically been thought of as a safe haven asset, a place that investors can consider when all other investment choices are struggling. However, gold has struggled itself this year, down a shade over 9% through September 23, 2022. This has some scratching their heads as to how and why this can be.

There are some drivers to gold that paint a negative picture for the yellow metal. The first of those is real yields. The FOMC, as well as other central banks, has kept real yields below zero for most of the post-Great Financial Crisis period outside of a few periods. However, this year the FOMC has focused on real yields and moving them higher. Using the 5-year real yield as seen in the TIPs market, this year we can see it has gone from -2% to +1.6%.  I have overlaid the inverse of this real yield vs. Gold futures. Higher real yields are negative for gold and have historically had a high negative correlation (-0.82) over the last 20 years. The reason for this is due to the higher opportunity cost of owning a non-interest bearing asset (in fact, a negative carry asset). If this correlation continues to hold, there might be more downside still for the price of gold.

Image 1: Gold futures vs. the inverse U.S. 5-year real yields

Some might suggest that gold should do well because of the increased money supply and the potential debasing of the dollar. However, while that was the case in early 2020, the rate of growth of M2 money has fallen sharply for the last 18 months. This is another potential negative catalyst for gold in the near term.

Image 2: M2 money supply growth vs. Gold futures

Another potential catalyst that I have also noted before is the growth of the federal deficit. If we look over the last 30 years, we can see that in periods of growth in the federal deficit, gold has done well. The federal deficit grew considerably during the Covid-19 period. With many of these programs rolling off, the growth of the federal deficit has also fallen, which might yet be another negative catalyst for gold.

Image 3: U.S. federal deficit as percentage of GDP vs. Gold futures

Technically, gold has broken below some levels of support. Looking at the Fibonacci retracement of the entire move from 2016 to 2022, there is a target that develops below 1550 down to 1435. The asset is not looking oversold at all. Recall the strength of returns in trend-following strategies such as managed futures. This trend is still relatively early in its development.

Image 4: Ichimoku chart with Fibonacci retracement for Gold futures

Speaking of managed futures, we can see these investors had been in the long position of Gold futures well into Q2 of this year, but in the last couple of months, the short position has built and now is larger than the long position. The trend must just be presenting itself to managed futures accounts.

Image 5: Commitment of traders report for Gold futures

Turning to the CME Group Volatility Index (CVOL), we can see where gold implied volatility stands relative to other metals products, as well as relative to its own history over the last year. At about 18.5, gold is lower than the other metals in the complex as well as the overall average. It is also near the lower quartile of its range from 13.5 to 32.7 over the last year. The implied volatility of gold appears to suggest that market demand for gold is low based on this metric.

Image 6: CME Group Volatility Index (CVOL) - metals

Comparing the current gold implied volatility to the most recent realized volatility shows that the spread may be at the widest level of the last 12 months but is not that wide in absolute terms.

Image 7: Gold implied volatility history

Finally, looking at the term structure of implied volatility, we can see the first two months on the curve appear to be the lowest point on the curve for gold implied volatility while the back part of the curve is more elevated. While the nearest contract may look the least expensive on a relative basis, the catalysts that we have spoken about – real yields, money supply, fiscal deficit, building managed futures position – probably require some time to play out. As a result, for a trade, one may consider the November period and not the October contract that may seem lower.

Image 8: Gold implied volatility term structure

Short gold call spread to finance a put example

Putting this together, I am looking for a bearish position. I am not afraid to be net long volatility given its relative pricing vs. the other metals and its own history. That said, any options we buy can be a drag on returns and we have to appreciate this, trying to reduce costs whenever we can to improve return possibility. With the macro catalysts I mentioned, as well as the slowing building trend-following position, give us some confidence that the upside in gold may be limited in the near term. Because of this, we might feel confident to sell upside options to reduce the cost of the spread. In this case, I have looked to sell an upside gold call spread struck at 1690 to 1730 to pay the premium for a downside option that takes advantage of the catalyst. I can use the premium to buy a 1590 put for November. There may be some traders that would prefer that any downside exposure kicks in early. If they are willing to spend some premium, the strike on the put can be moved higher. In addition, if traders are willing to take open-ended exposure on the upside and not buy the 1730 call to cover their risk, a higher strike put can also be purchased.

Image 9: Breakeven analysis for a long put funded by a short call spread in gold

One may also prefer to analyze using the matrix function in QuikStrike. Clearly, a quick move lower that corresponds to higher volatility would be the best result for this idea.

Image 10: QuikStrike Matrix for the gold spread


Turning to another metal, copper, I wanted to follow-up on some things we had spoken of before. We had discussed how and why copper is correlated with the direction of the economy. The news on the economy has only worsened over the last two months. Copper has been following the U.S. economy lower, tracking the U.S. PMI. We will be getting new readings on the U.S. PMI in early October. The expectation is for a continued move lower, which might also point lower for copper.

Image 11: Copper futures vs the US PMI

Copper is also closely tied to the housing market because of its uses in plumbing and electrical. While some of the housing data was a little better than expected in the last week, most housing data continues to be quite weak and with the FOMC still solidly in play. There are some that are getting quite nervous about the U.S. housing market. We can see in the next chart that Copper futures move coincidentally with the U.S. housing market whether that is the NAHB Index, Housing Starts, or Existing Home Sales.

Image 12: Copper vs. NAHB, Housing Starts, and Existing Home Sales

Figure 13 shows an updated chart I used the last time I spoke about metals. You can see the circles where I was suggesting futures might be oversold and at support, setting up the potential for a bounce. We did get a bounce in Copper futures, but it was very muted and now the market is heading back lower. There is still some support in the 319 area vs. 337 last.

Image 13: Ichimoku chart with Fibonacci support and resistance for Copper futures

You can see the indecision among the trend-following crowd with both short and long positions about the same size, showing no meaningful lean in either direction. The technical chart shows some indecision and investor positioning shows some indecision.

Image 14: Copper Commitment of Traders

Copper implied volatility looks relatively priced whether looking at the CVOL chart in Image 6 or comparing the level of implied volatility vs. realized volatility.

Image 15: Copper implied vs. realized volatility

Risk reversal prices have been tracking Copper futures, so we see the downside strikes pricing in more of an insurance cost than the upside strikes. The upside strikes may not be appealing on a direction basis but could present an opportunity on a volatility basis.

Image 16: Copper 25 delta risk reversal time series

While we need to ignore the October contract since it is expiring soon, the November contract is priced at a discount to the rest of the curve. In my opinion, this may be a bit surprising given the amount of potential catalysts coming out in the next month, even if the contract expires before the next FOMC meeting. Even before the meeting, we may receive enough economic data globally in the next 30 days to make the decision much clearer.

Image 17: Copper implied volatility curve

Knowing upside strikes look relatively appealing, I have tried to capitalize on the indecision in the market combined with upcoming economic catalysts to get a long delta-hedged call, struck at 3.50. I can buy this at a 29.3 implied volatility, which is lower than the ATM and lower than downside strikes. Since I hedge it at the time of trade, you can see from the breakeven chart I essentially have a straddle position. The breakeven on the downside is closer than if I bought an ATM straddle. My risk of this idea is a slow grind to the upside strike. I am banking on the catalysts changing the indecision of investors and a move that will not be slow, but rather quick as investors will want to add to positions.

Image 18: Breakeven chart of a hedged November 3.50 call

If I use the simulate tab in SpreadBuilder, you can see the P&L in three different scenarios: Up Fast, Up Slow, and Down Fast.

Image 19: Down Fast

Image 20: Up Slow

Image 21: Up Fast

I am rooting for a fast move in either direction, but if it is going to be a slow move, I am rooting for it to be lower and not higher. No position comes without risk, and given the set-up in the market, I am willing to take this risk into the catalyst of the next month, since we are at a potential inflection point for risk-taking, with indecision in the copper market.

Good luck trading.

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