Executive summary

Rich looks at an April short call spread vs. long put to explore the possibility of an out-of-consensus move lower in the price of gold.

Gold investors commonly share a perception that the purchasing power of fiat currencies will decline due to factors such as inflation, expansionary monetary policy, and the rising national debt.

In fact, if we look at the performance of gold under various central bankers, the move higher under Chairman Powell looks similar to the moves under Arthur Burns or Ben Bernanke, who were thought to be very dovish central bankers, than under Paul Volcker or even Alan Greenspan, the former who are considered the most hawkish of central bankers. In spite of Powell having one of the fastest rate-hiking regimes in history (except under Volcker), the market has still seen the chairman as quite dovish.

Perhaps, the liquidity being provided to the struggling banking system only exacerbates that view among the precious metals community.

Image 1: Gold price under different central bankers

However, having traded precious metals for a Swiss Bank back in the 90s, I always found there were different drivers to the flows I was seeing in the gold market. For many investors, the move into or out of gold had much more to do with the real rates available in the economy. The higher the real rates, the worse gold would do. The lower the real rates, the better gold would do. Perhaps, this is not inconsistent at all with the view above, in that low or negative real rates have the potential to de-base a fiat currency.

In this chart, I use the real rate as determined by the 10-Year TIPS market, taking the inverse, and compare it to the price of the generic front month Gold future. There is a very tight relationship for the past 17 years, which became quite disconnected in the last nine months or so. Gold prices have continued higher even though real rates have gotten much more positive (negative on this inverse graph).

Image 2: 10-year real rate from TIPs market vs. gold

That is very intriguing to me and if I had to guess it is because the yield curve itself has really changed shape pretty materially, going to one of the deepest inversions we have seen in quite some time. Unfortunately, there are now 2-Year TIPS but if I create a real yield in the 2-Year using CPI and 2-Year Treasuries, there is a more volatile relationship that still largely holds. Real rates in 2-Year have stayed negative (this chart is also inverse, so they appear positive on this graph) supporting the move higher in gold.

This explains much more of the late 2022 move higher in gold. However, it still does not explain why gold is still so high even though real rates in 2-Year is much less negative than they have been. The move higher in 2023 as real rates got more positive still stands out to me.

Image 3: CPI less 2-Year Treasuries vs. gold

Naturally, I want to ask what could be driving this? My opinion would be institutional holders understand the link between real rates and gold, but perhaps retail traders do not. As such, I chose to look at the shares outstanding in the GLD ETF, with the notion that perhaps money flowing into the GLD ETF is driving Gold futures higher.

There is a very tight relationship over the past 10 years, however, there is also a disconnect in the price of gold and the flows into or out of the GLD ETF.

Image 4: Shares outstanding in GLD ETF vs. gold price

Now my interest is peaked. Perhaps it is just a technical trade? I go to my daily Ichimoku charts and see that the Gold futures did break above the Ichimoku Cloud back in November and have rallied ever since. In March, there was a pullback, but we found support in the cloud and bounced strongly. This was likely driven by the ongoing banking crisis and the actions taken to address it. With fears of the economic fallout and the concern that the response will de-base the dollar, the move into gold makes sense.

However, this move higher in gold has become extreme. I circle all the times in the past year that Gold futures have moved above 70 on the Relative Strength Index (RSI). If you follow the arrows, you can see that in each case the price of gold has moved higher. This has not necessarily changed in trend, but it has been a tradable move lower in the price of gold.

Image 5: Ichimoku and RSI technical chart of GC1 futures

Now I want to consider the charts of gold on a weekly basis over a longer period of time. Surprisingly to me, the charts look much more bearish than the daily charts. Gold prices have rallied recently but only into a resistance level. It is in the Ichimoku Cloud and a break below that support could spell downside at least to the 1600 level seen late last year.

If I add that the Moving Average Convergence Divergence (MACD) is rolling over and moving lower, this is a very bearish sign. Finally, I look at the RSI and see the times it has trended lower in the last five years (arrows) I have seen a move lower on the weekly charts. This all paints a bearish technical picture for me.

Image 6: Ichimoku Cloud with MACD and RSI on a weekly chart

What is the options market telling us? The first step for me, given the sharp near-term moves but a more negative trend, is the level of skew in the market. With this much volatility, what is the end-user preference for calls compared to puts? I focus my attention on the weekly April options and see the skew in favor of calls is extremely steep. For 15 delta calls vs. puts it is almost 5 vols. In fact, put implied volatility is trading below the at-the-money volatility. This suggests the move higher may be causing some pain to traders. However, it is an extreme relationship that might be beneficial to the trader with no position.

Image 7: Gold implied volatility by delta for April options

I look at this same skew measure using QuikStrike’s QuikSkew view and notice that the current levels of skew are quite extreme relative to the history that goes back to the beginning of 2007. Not only does the level of skew look extreme in absolute terms in the near-term, but it also looks extreme relative to its own history. This is very interesting.

Image 8: Historical gold skew

Thus, I combine a near-term bearish view on futures with the view that the skew is extreme. I naturally want to sell calls and buy puts. Though, I appreciate that there may be some pain to the upside which is causing the skew. I also appreciate that in this current market duress, unhedged short options are not particularly appealing to many traders. Thus, I look at selling a call spread to buy a put. I have risk on a call spread but it is limited to the distance between strikes. The benefit is that selling the call spread on high vols enables me to buy the puts at zero cost. I could just consider buying the puts outright, which also makes sense, but I thought this trade provided a bit more leverage while still limiting the risk on the idea.

I looked at the weekly April options to go a little beyond the standard April that expires sooner. The weekly options have been growing in popularity and in volume. The strikes that lined up in OGJ2 were selling the 2025-2075 call spread and buying the 1930 puts for zero cost. I pick up about 2 vol points between the 2025 and 1930 because of the skew but give some of that back, buying the further out of the money calls. The trade does not take full advantage of the skew, but it does limit my risk, which I think is a prudent step to take in uncertain macro markets. The breakeven on the downside is 1930 and my profits go up one to one below that. At expiration, my breakeven is 2025 on the topside but my risk is limited to the distance between the strikes. Limited risk for unlimited potential reward is my kind of trade.

Image 9: Expected return of April Short 2025-2075 call spread to buy 1920 puts

These are the Greeks of the trade below. The lower futures go, the more the long gamma will kick in. At the time of the trade, there is very little in Greek exposure. This is more of a breakeven idea than it is a trade to get long or short gamma and vega. This is somewhat by design as the level of volatility itself did not really stand out when I looked at the CVOL tool. There was no strong signal there, so I didn’t want to take a lot of vega risk.

Yet, getting long gamma at a level and a time when there could be some breakdowns on the technical charts is an appealing idea to me.

Image 10: Greeks and Profit/Loss of the option spread

In times of turbulence, there is always an appeal for the flight to quality or flight to safety in the precious metals market. Still, sometimes that can get too extreme and present the opportunity for a countertrend trade. I think this is one of those times.

Good luck trading!

To subscribe to new issues of this report, including a new monthly Ags option report, visit cmegroup.com/excellwithoptions

The opinions and statements contained in the commentary on this page do not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs. This content has been produced by [Data Resource Technology]. CME Group has not had any input into the content and neither CME Group nor its affiliates shall be responsible or liable for the same.


CME Group is the world’s leading derivatives marketplace. The company is comprised of four Designated Contract Markets (DCMs). 
Further information on each exchange's rules and product listings can be found by clicking on the links to CME, CBOT, NYMEX and COMEX.

© 2024 CME Group Inc. All rights reserved.