How To Prepare For Gold's Rising Volatility

| About: SPDR Gold (GLD)


Higher rates make investment in the dollar stronger, giving higher yields versus gold’s zero yield – but few investors incorporate this fact into their speculative positions.

A year from now, looking back to today, we will see gold as underpriced.

However, today, gold sits at a relative high, with volatility at a relative low.

The best way to play gold at the moment is to be long both on gold and on gold's volatility.


Now Is Not the Time to Play Gold…

In my previous article on the SPDR Gold Trust ETF (NYSEARCA:GLD), I explained why holding gold will make you rich during the coming market crash. To summarize that article:

  1. Huge spikes in gold buying by hedge funds are likely fueled by fears of a coming recession.
  2. The Federal Reserve's policies are pushing investors toward gold.
  3. China and India are driving demand up.
  4. Gold miners have cut down on production, hurting supply.
  5. Currency wars will have only one clear winner: gold.
  6. A $419,000 investment in gold should turn you into a millionaire during the next market crash.

In this context, I should explain that adding to your gold position should not be performed at random. Rather, you should investigate the characteristics of gold to find the right type of play. Two issues tell us that gold is not yet ripe for buying: volatility and FOMC meetings.

In another article I wrote on gold, we looked at how gold reacts in respect to the FOMC meeting cycle. I admit that my statistical analysis on GLD post-FOMC meetings was focused only on the idea of the meeting - not the results of the meeting. Because I included dates going back to 2004, when interest rates were high, the sample was skewed. I now will run the same test, but only over the time period at which interest rates have been near-zero:

We see a slightly different pattern, with gold overperformance peaking about a week earlier than that of the previous study. That is, if you're setting your dollar cost averaging strategy to be based on the FOMC meetings - with good reason, as we will discuss briefly - you should aim for adding 9 days after the FOMC meetings. So, adding now would be a bit early, as the next FOMC meeting is April 26.

… But The Time to Play Is Near

The time to play is near, both because the FOMC meeting cycle has started and because a market crash is near. I've discussed the catalysts for the coming market crash in several different articles, so for now, I'd like to talk about the relationship between interest rates and gold. Most investors are aware that the relationship is likely inverse: Higher rates make investment in the dollar stronger, giving higher yields versus gold's zero yield - but few investors incorporate this fact into their speculative positions.

If they did, gold would be rising quickly at this moment, when the probability of a rate hike is 0%. If you track gold against the previous rate hike of 25 basis points, you'd see that it dropped 10%. Low interest rates keep gold afloat, and position adding should take place when interest rate hikes are improbable.

Notably, after the Fed turned dovish (supposedly "learning their lesson" after the first rate hike), gold reached its relative high. Note that playing gold when both it and the general market are at relative highs should be considered a contrarian play. Going long on gold now is essentially making the statement that you believe a recession is near.

Even this month, analysts are calling out to short gold - such as Goldman Sachs' head of commodities. Of course, with interest rates so low, companies should be able to take out debt and finance corporate growth, making gold an illogical investment in this respect. But two problems with this idea permeate the market: A recession, now evidenced by falling corporate earnings is near, hurting corporate growth prospects. Gold is bought by non-US investors as well and is a safe holding for the increasingly many countries with negative rates.

The latter point is especially convincing for a long position on gold. With countries such as Japan devaluing their own currency, and countries such as China hoping to devalue other countries' currencies (i.e., the US's), we should see gold strengthen against many of the world's currencies, perhaps all at once. Interestingly, China has recently pegged the Yuan against gold, perhaps as a bet that gold will strengthen against the dollar.

The former point could spur government intervention. Facing a recession, the Fed likely wants lower interest rates. They could cut rates back to 2015 levels. They could engage in another round of QE as an indirect way to cut rates. Or they could join Japan and engage in negative rates. I'm of the belief the Fed will choose the option that looks smartest in the short term but most foolish in the long term - this option is negative rates. Indeed, the Fed put this option on the table back in February, and with the Fed recently turning dovish, we could be already heading in that direction.

Negative rates will be the swansong for the 7-year bull rally and for the asset market that has been bolstered by central bank intervention and corporate buybacks. But it will also mark the beginning of a gold bull market. Once the largest economy in the world drinks the Kool-Aid, the gold bull rally is really on.

So for now, your eyes should be on the Fed and the results of FOMC meetings. The Fed will be the catalyst to send gold into a bull market. A year from now, looking back to today, we will see gold as underpriced.

Gold's Volatility

However, today gold sits at a relative high, with volatility at a relative low:

What's particularly interesting about the chart above is how gold's volatility increased as the price rose, hitting a peak when the price stabilized. This is the opposite of what we see in the general market. For example, the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) tends to drop when volatility, as measured by the VIX, rises.

We can take advantage of this situation by playing long volatility, long gold strategies. In options terminology, this is long vega, long delta on GLD. The idea is that our strategy stands to profit doubly when gold is on the rise - increasing in value both because of the underlying rising and because the volatility of the underlying is rising.

How to Play Gold, Incorporating Volatility

Many gold bugs are already holding long gold positions, either via GLD or the Market Vectors Gold Miners ETF (NYSEARCA:GDX). But when gold rallies, these positions will not benefit from the spike in gold volatility. Holding stock is a vega-neutral position.

A superior strategy will be long on vega. Because we have no immediate signs of a gold rally, I suggest an option strategy that is also theta hedged. This means that our option strategy should limit its exposure to time decay.

One strategy that allows us to be long delta, long vega, and theta hedged is the bull debit spread, in which we buy a call option of a low strike price and sell one of a high strike price. The most popular debit spreads of this type on GLD appear below:

Click to enlarge

With GLD currently at roughly 120, you can see that these spreads place 120 either in between the two calls or at the bought call. Unfortunately, surrounding the price of the underlying with the two calls puts us short vega. This means that the most popular bull debit spreads on GLD will actually lose value when GLD rallies, as the volatility also rallies:

Click to enlarge

Instead, we want to be long vega, which means that we want to be out of the money for both calls:

Click to enlarge

Currently, the highest vega bull debit spread on GLD is given below:

Click to enlarge

By spending only $200, you go long delta, gamma, and vega, mimicking roughly 35 shares of GLD. Your reward/risk ratio is 6.5:1. The spreads are tight, so you could get this easily and without stress through a simple market order.

Ignoring the direction of GLD, should we see a spike in volatility such as the one in February, your spread stands to gain roughly $220. That is, we don't even need GLD to move - we just need it to become more volatile to double our investment. With all the news surrounding gold, I think increased volatility is an inevitability, and any gold investors would be well advised to distribute a portion of their gold investments to the above debit spread.

With the FOMC meeting next week, we might see that spike in volatility we are looking for. If you're of this idea (i.e., long vega), buy the above debit spread today. But if you're more of a long-delta investor (i.e., you believe gold will increase in price but not volatility), buy May 9 - buying 3 of these will allow you to mimic 100 shares of GLD for only $600.

Click here for more options strategies on gold.

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