- The market preference for gold calls versus gold puts switched: A fundamental change that has occurred in the gold option market over the last ten years has been the switch in the skew from a preference for gold calls to a preference to gold puts. Prior to 2010 we can see that the skew had generally been positive (white line) but it swung sharply negative in 2012 and 2013 matching the move lower in the gold price. Gold historically has generally 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. This characterization as a defensive asset was reflected in the positive implied volatility skew – in other words markets were willing to pay a premium for gold calls versus gold puts because of this diversification benefit that gold was expected to provide to a portfolio.This has since changed and the last two years have been characterized by the gold skew being persistently negative i.e. markets are willing to pay a premium to own gold puts versus gold calls. It is perhaps 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 ETFs, 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. The sharp preference for gold puts experienced in 2013 has since moderated with the skew approaching balance (zero). While it is still too soon to say with certainty what the trend will be for skew going forward we would suggest that should there be rising demand for gold, driven for example by an escalating conflict in Ukraine, we would expect the skew to turn positive again, indicating a market preference for gold calls.
- The correlation between the gold spot price and gold implied volatility: By looking at the gold volatility skew an investor is able to infer what is likely to happen to gold option volatility as the price of gold either rises or falls. For example, a positive skew implies that the market expects a positive correlation between the spot price and implied volatility – as the gold price rises the market would expect implied volatility to also rise. And this is indeed the relationship we have observed historically: with positive skew, rising gold prices have been associated with rising implied volatility and with the negative skew, falling gold prices have been associated with rising implied volatility. In fact it can be shown that the gold skew is an alternative numerical expression of the expected correlation between the gold price and implied volatility.
Chart 2: Gold Implied Volatility Skew
Source: Bloomberg LP
- S&P implied volatility skew: As a final observation we note that the S&P 500 Index implied volatility skew, in contrast to gold skew, has been persistently negative reflecting the premium that investors are willing to pay to own equity puts versus equity calls, as protection against falling equity prices. Whilst gold skew has been negative in recent years, the generally negative relationship between gold skew and equity skew could be interpreted as a measure of the markets’ value of gold’s potential portfolio diversification benefits.
Chart 3: S&P 500 Implied Volatility Skew (lower chart white line)
Gold Implied Volatility Skew (lower panel, white line)
Skew is defined as the implied volatility of a gold call with a 25% probability of being exercised minus the implied volatility of a gold put 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), share their thoughts about the gold space.