By David Russell
Silver had its biggest drop in 28 years this month, and one analyst says option pricing was the writing on the wall. Jeffrey Rosenberg of Bank of America / Merrill Lynch, who normally focuses on the credit market, observed a surge of implied volatility in precious metals in the month preceding the crash. He likened it to a similar pattern in the Nasdaq stock market before its bubble broke in 2000.
Implied volatility is a measure of demand for options, which reflects the market's view on how much a stock or commodity is capable of moving. It tends to rise during a downturn because investors scramble for puts as a downside hedge, and to fall when a market is trending higher. "But when expectation for the underlying index shift towards persistent increases, the relationship can reverse," Rosenberg wrote. "Demand for levered long risk exposure through speculating by purchasing call options on the underlying index leads to option implied volatility rising."
We spotted this trend in late April and posted frequent alerts about the extreme option activity in the iShares Silver Trust exchange-traded fund (NYSEARCA:SLV), which had become a popular instrument among the silver bulls. Implied volatility on the fund climbed from about 35 percent in early April to 43 percent by the end of the month, according to our data. The SPDR Gold Trust (NYSEARCA:GLD) saw a similar development, although it was less dramatic.
The use of implied volatility has become increasingly common in recent years as options gain popularity. The Chicago Board Options Exchange Market Volatility Index, also known as the VIX, measures the cost of options on the S&P 500 and is perhaps the best known instrument