Liquidity in gold option trading has risen significantly over the last five years. Using the COMEX 100 ounce gold option contract as a proxy for the market, Year-to-Date Average Daily Volume has risen from approximately 30,000 contracts in May 2009 to 70,000 contracts (~ 217 metric tonnes) in May 2014. This period of growth in option use has coincided with the rapid rise in the gold price after the 2008 credit crisis and perhaps reflected a need from the growing number of gold investors for derivative contracts with which they could manage the risks inherent in their gold exposure.
Source: CME Group
A key benefit of having a liquid and actively traded option market is the market information that can be discerned from option prices, giving an insight into the supply and demand dynamics of the market. In this week’s commentary we look at a ten year history of gold option prices and highlight some of the key characteristics evident in the data. We also look at the equity option market through the price history of the CBOE VIX index and draw parallels between the two option markets.
In this analysis option prices are expressed in terms of implied volatility rather than dollars and cents. A key input into the calculation of option prices is a parameter called “volatility”. In effect it is the market’s estimation of the amount of volatility (typically defined as the variability in daily moves) in the gold price that is likely to be experienced during the life of the option contract. In general the higher the level of expected volatility, the higher the option price in dollars and cents. Volatility is typically expressed as a percentage on an annualized basis. For example, a one year volatility of 20% would imply that the expected standard deviation of the gold price over the next year is 20%. Ultimately expressing volatility in this way is useful as it allows direct comparisons of the potential movement in asset prices across different markets, as implied by option prices.
We highlight below some of the more interesting characteristics of the gold option market:
- The absolute level of volatility: Over the last ten years the spot price of gold in dollars has had approximately the same level of volatility as a broad based large cap equity index (the S&P 500). It is perhaps worth also making the point that the volatility of gold bullion has been significantly lower than the volatility of a broad based index of gold mining stocks. For example, the historical volatility of the NYSE Arca Gold Miners Index (42% annualized) has been just over twice the volatility of the gold bullion spot price (20% annualized) as measured by daily price movements over the last 10 years. This point is worth remembering given the common practice of using gold mining equities as proxies for gold bullion. The two assets provide exposure to really quite different types of risk and this is reflected in the large difference in historical volatility
- Volatility is contagious: It is also noteworthy that implied volatility in the gold market has tended to track the movement of implied volatility in the equity market. This is noticeable particularly during periods of market stress such as in 2008 and 2011 where a spike in volatility in one market was mirrored in the other market. In fact, unsurprisingly, this is a phenomenon we tend to observe across all markets where significant declines and falls in volatility tend to be reflected across all markets.
- Volatility has fallen sharply in 2014: In synch with volatility in other asset classes, implied volatility in gold markets has fallen sharply in 2014 tracking the much lower day to day volatility in the gold price. The prior low in one month implied volatility was 10% reached in July 2005.
Chart 1: Absolute level and co-movement in gold bullion implied volatility versus CBOE VIX Index
Source: Bloomberg LP
A key metric that provides important information about the balance of supply and demand in the gold market is the implied volatility skew. A detailed discussion of volatility skew is beyond the scope of this article but broadly speaking the skew is a reflection of the market’s preference for owning gold calls (expectations for gold prices to rise) versus gold puts (expectations for gold prices to fall). When the price for a given out-of-the-money gold call as indicated by its implied volatility is higher than the price for an equivalent gold put, the skew is said to be positive meaning that the market demand for gold calls exceeds the demand for gold puts and as such the market clearing price for gold calls is higher.
In the following chart we plot the gold implied volatility skew. The specific metric we plot is the difference between the implied volatility for a one month gold call with a strike price that has a 25% probability of being exercised (at inception) versus the implied volatility for a one month gold put with a strike that also has a 25% probability of being exercised. The benefit of defining the skew with reference to the probability of exercise is that it standardizes the price units and as such allows the skew to be compared across different option markets.