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Options Action Fuels Volatility In Precious Metals

In the first fortnight of November, spot gold has traded (all prices in US$/oz) from 1339 to 1424 and back to 1360. Silver has traded from 24.50 to 29.00 and back to 25.50. Since the July lows, gold has been up 23% and silver a staggering 65%. There are no prizes for guessing why the rallies, with QE2 unable to hide in any room. But the curious thing is that open positions in Comex precious metal futures and positions in precious metal exchange traded funds have actually declined in November. One would have naturally assumed an increase of speculative activity judging by the price surges. RBS notes speculative gold positions on Comex are down 14% for silver since September and 8% for gold since mid-October, while ETF positions in both are down 1% since mid-October. Physical buying is not the driver, given there have been no central bank purchases of any note, and given the Indian festival of Diwali is now over there has been a rapid fall-off in Indian jewellery demand. Comex did increase its required margins on silver last week, but that only affected some switching from futures to ETFs and does not explain the overall decline in positions vis-a-vis stronger prices. So what does? Well maybe a clue lies in the recent volatility of daily prices movements. What won't show up on the data are large positions taken by larger players, who may be commodity funds for example, who are buying precious metals through over the counter (OTC) options transactions. What will show up on the data are equivalent listed options over Comex futures. RBS notes there has been growing interest in Comex gold call options, for example, all the way from the 1200 strike (exercise price) up. Currently the largest open positions for the December 10 expiry contract are at the 1400 and 1450 strikes. If one buys a call option one does not directly impact on the spot metal price. One has simply bought the right to buy at the exercise price on maturity. However the proprietary market-maker who sold the call option will impact on the spot price because he will need to hedge his position in futures (and in physical gold in the case of OTC options). This is known in the trade as a “delta hedge”. If you buy a call option from a market-maker which is “at the money”, meaning the exercise price is at the current futures price, the market-maker considers this a 50/50 bet as to whether or not it will be exercised. This “50 delta” incorporates no view on gold, it is simply mathematical on a probability basis. If gold subsequently rallies, then the call option you bought becomes “in the money”, meaning the futures price is now higher than the exercise price. This means there is a greater chance of you exercising the option - let's say it's now a 65% chance. When the market-maker sold to you on a 50% chance, he would have bought on Comex 50% of the volume of options as futures contracts to “delta hedge” the chance of you exercising the option. (When you exercise, the market-maker has to give you gold futures at the exercise price). To catch up with the now 65% chance, he has to buy another 15%. So as the price of gold rises, market-makers are forced to chase their hedges by buying into the rally. Naturally this would exacerbate the rally, which further forces more purchases. The flow feeds on itself. But if there is a turnaround in price and gold pulls back a bit, market-makers then have to sell off their hedges and once again chase the market, this time to the downside. In other words, delta hedging of the short options held by market-makers heightens volatility in the underlying futures (which flows through to spot gold) and, in the case of OTC's, spot gold. When expiry is a while away, changes in delta hedge requirement are slower. As expiry approaches, those changes (known as “gamma”) are far more rapid. Hence volatility can reach extremes as expiry nears and the closer the futures price is to the relevant strike price the more those buy/sell requirements flip about. RBS has looked at trading activity and noted that in one example, one day's trade based on delta hedging equated to 20t of gold purchased (albeit in paper futures). To put that into perspective, ETF inflows to date in the second half 2010 have totalled 26t (this time real gold is bought by the sponsor). It's not hard to see why delta hedging can have a significant impact on market moves. The way Comex options work is that the last day of trade for the December 10 expiries is on November 23. Looking at the most widely held strikes, RBA suggests that if gold is between 1400 and 1450 and silver between 27 and 30 as this date approaches then look out for “fireworks”. By Greg Peel