Golden Volatility Adds to Allure of High-Convex Defensive HedgesBy
Low rates volatility has cheapening effect on gold optionality
Carry is still expensive given depressed realized volatility
Risk-off option structures on gold that have low premiums and high convexity exposure may be attractive to hedge a full-blown crisis from either geopolitical risks or White House turmoil.
Even amid heightened U.S. political risks, ongoing tension with North Korea and the collision of budget and debt-ceiling deadlines in the autumn, gold’s implied volatility is trading at relatively low levels. The decline in volatility for U.S. real rates is an important factor in this: investors typically measure the relative attractiveness of holding the metal -- a non-interest bearing asset -- against those that generate yield. As interest rates increase, the opportunity cost of holding gold rises.
With monetary policy normalization a headwind for gold, the binary nature of North Korea and U.S. political risks may see low-cost, high-convex option structures gain interest. With at-the-money (ATM) options expensive to carry given depressed realized volatility, low-delta out-of-the-money (OTM) call options or one-touch structures may appeal because they incur little cost if implied volatilities move lower on any de-escalation of risk.
The GLD ETF one-month implied/realized volatility ratio at 1.2 highlights the expensive carry of holding ATM options.
Game theory suggests that the probability of a conflict is low, given positive diplomatic outcome is best for both sides. Though the risk of North Korea becoming able to launch a nuclear intercontinental ballistic missile is making the matter increasingly more urgent for the U.S.
A regime shift in volatility will be best captured with long-convexity exposure combined with tactical shorts, rather than tail-risk strategies betting on mean-reverting volatility spikes.
- Short-dated implied volatilities are trading below their 1-year medians with 50-delta 3-month GLD ETF at 11.4%, 16th percentile.
- GLD 1-month one-touch option with barrier of 135 has a payoff about 26:1. However, the upside is capped, while the 130 call (~6% OTM) costs just 23c and 135 call (~10% OTM) at 9c, and provide a highly convex payout profile compared with an ATM call.
- NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.