Volatility, Price Bubbles in Gold and Silver Expected

by: Joe Kunkle

The recent surge in the prices of gold and silver is no secret, as it seems the major media networks have devoted far too much time discussing the commodities that are hitting new highs almost every day.

The long gold/silver and short the US Dollar trade has gained too much popularity and everyone continued to pour money into a seemingly "easy-money" trade that worked for months. Any time you see a situation like this there is an opportunity to be the first to take the other side of the trade when certain factors surface that point to an over-crowded trade.

Between CNBC guests calling for $2,500 gold (more than double current prices), the US Mint running out of gold coins, gold companies unravelling hedges, and even my grandparents beginning to talk to me about the price of gold, it is obvious that a bubble is forming, although it takes a certain fortitude to bet against John Paulson, an active buyer of gold companies and known for making some of the greatest trading calls in the market's history.

Recently, Barrick Gold (NYSE:ABX) did away with its hedges to gold, a major gamble that reminds me of how devastated the airline industry was, for the most part, when many of the airliners were un-hedged against the price of crude oil that topped $150 a barrel. On Friday, Barrick traded in a 10% range, as gold prices plunged.

Economist Blake LeBaron once discussed this relationship, basically saying that when everyone is on the same side of a trade, the crash is soon to come. We saw a mini-view of this on Friday as Gold prices weakened and with everyone looking at the same technical levels, sellers triggered a volatile move lower throughout the day.

I follow the action in the options market every day because that is usually a leading indicator for where a market is heading. On Friday, for the first time in more than 6 months, I began to see cautious positions trade in individual gold and silver miners.

Barrick Gold was very active Friday with 70,266 calls and 65,534 puts traded, around 4X average volume in each. Nearly $1 million in net premium was purchased on the day, and the net delta of all option trades reflects a bearish outlook for shares, and for gold itself. One noticeable trade was a 1,000 contract strangle sell in July, $60/$35 for $4.90, a bet against volatility and seeing limited downside in shares to around the $30 mark.

Pan American (NASDAQ:PAAS), a silver miner, saw a trader sell 2,000 July $35/$17.50 strangles with shares at $25.50.

Standard Silver (NASDAQ:SSRI), another silver miner, was targeted with June $30/$17 strangle sellers, with shares at $23.62.

Iamgold (NYSE:IAG) , gold miner, had a seller of the June $25/$12.50 strangle for 500 contracts.

There was also sizable (25,000+ contracts) closing in both December and February calls spreads in the Gold ETF (NYSEARCA:GLD).

With the Volatility Index for the market, the VIX, still sitting near 1 year lows, the implied volatility in these silver/gold miners is approaching 1 year highs, also reflected by the Gold Volatility Index (GVZ), which broke to 6 month highs on Friday, gaining 11%.

I am in no way trying to call a top in gold, as many of the fundamental reasons behind higher gold prices still make a lot of sense, but you have to respect trends in this market, and the action is reflecting caution of this irrational exuberance.

You can draw further conclusions from this action as well, as the trading is likely looking for a summer 2010 increase in interest rates, and also looking for the US Dollar to find some stability over the next few months. This is backed up by the heavy buying seen in the US Dollar Bull (NYSEARCA:UUP) fund on Friday, as one trader bought 20m000 June $23 calls, and others piled into January $23 calls, buying at the offer in aggressively bullish fashion.

If you trade options and are interested in collecting premium, and being on the side of the "smart-money", I can see a whole lot of reasons to sell volatility in the gold and silver miners, and also begin to explore long positions in the US Dollar.

Disclosure: No Positions in Above Mentioned Securities