It is often a valuable exercise for investors to monitor the option market associated with the cash market as option markets may carry useful information about how the balance of supply and demand in the cash market is evolving over time. In this week’s note we review the history since January 2006 from when we have available data, of the market’s relative preference to own gold calls (seeking to profit from rising gold prices) versus owning gold puts (seeking to profit from falling gold prices) and how this has related to the price action in the gold cash market. To guide our discussion we have constructed an index of the gold market’s “put/call preference” which is simply a measure of the difference in price between a 1 month gold put option and a 1 month gold call option that both have the same strike1. It is important to note firstly that the absolute level of the index has no meaning and readers should focus instead on changes in the level of the index relative to the zero line. An index level of 0 (zero) indicates that there is no difference in price between a put and call while an index level above 0 indicates calls are more expensive than puts and vice versa. The rationale for why this preference persists is that it is simply a reflection of market supply and demand with an index value above 0 indicating greater demand to buy gold calls versus gold puts and an index level below 0 indicating greater demand to buy gold puts versus gold calls. A chart of the gold price in US dollars is also included (right hand axis).
Source: Bloomberg LP; Treesdale Partners calculations; past performance is not indicative of future performance
The first pattern of note is that unlike in equity markets where there has been a persistent premium for the price of put options to be greater than the price of call options, in the gold market the premium has swung between calls and puts over the eight year period. In the equity market the persistent premium for equity puts is a reflection of the market’s willingness to pay a premium to own puts as protection against the risk of equity prices falling sharply – in effect it is a ‘crash protection’ premium that an investor must pay to own equity puts versus equity calls. In contrast, in the gold market, in the period prior to January 2010, the premium tended to be firmly in favor of gold calls but then swung sharply in favor of gold puts during the period starting in January 2013 as the gold price began its precipitous fall from the $1800/oz highs. Gold historically has been seen as a defensive asset to hold in a portfolio. This meant that during periods of market stress, while the prices of assets such as equities might be expected to fall, the price of gold typically rose as investors sought out assets that were perceived to provide “protection” from falling markets. In essence because gold was perceived by the market to be an asset that performed positively during periods of high investor risk aversion, the market demanded a premium to own gold calls – said differently markets were willing to pay a premium for gold calls versus gold puts because of the diversification benefit that gold was expected to provide to a portfolio.
It is notable then that over the last two years this preference for gold calls switched with markets willing to pay a premium to own gold puts versus gold calls. And it is of course no coincidence that the switch occurred during a period of rapidly falling gold prices. While we do not pinpoint one specific cause it seems likely that with the surge in gold speculation over prior years, as evidenced by the rapid rise in the gold bullion holdings of the most prominent gold ETPs, many investors sought to buy protection from falling prices via purchasing gold puts – in effect the balance of supply and demand switched very strongly in favor of gold puts and this was reflected in option prices. In addition the dramatic fall in the gold price during a period of strongly rising equity prices perhaps also caused a shift in the perception that gold’s defensive qualities had been weakened thereby reducing the attractiveness to investors who wanted to own gold as protection for their portfolios.
The sharp preference for gold puts experienced in 2013 has since reversed and recently turned to favor gold calls. This is consistent with recent price action seen in the gold market with sharp spikes in the price coinciding with worsening news from both Ukraine and the Gaza Strip and indicating that as an asset it appears to have regained some of its defensive qualities. With investors once again seeking to hold gold as protection, this shift in preference is being reflected in the prices of gold options. And certainly the swing in the premium to owns gold calls is supportive of the view that gold prices should find buying interest at current levels from investors seeking non-correlated assets for their portfolio, especially in an environment of rising geopolitical risk.
1When expressed in terms of the probability of exercise on the inception date of the option contract. We focus on options with a 25% probability of being exercised.
This article was written by Treesdale Partners, portfolio manager of the AdvisorShares Gartman Gold/Euro ETF (GEUR), AdvisorShares Gartman Gold/British Pound ETF (GGBP), AdvisorShares Gartman Gold/Yen ETF (GYEN) and AdvisorShares International Gold ETF (GLDE).