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Trading Gold & Silver: A Realized Volatility Approach

First of all, I’d like to thank Nick Pritzakis for editing and revising the article.

Now, gold and silver are amongst the most heavily traded commodities in the world. Not only that, interest towards precious metals has been growing at an exponential rate. Many investors, institutional and retail…use them as a way to diversify their portfolios. Of course, this is an attempt to reduce their exposure to the equity markets, as well as hedge against the potential fear of inflation.
In fact, many market participants rush to buy precious metals, particularly gold, during sharp retracements in the equity market, as well as, when we’ve had political instability and the threat of war.
It’s no secret that gold and silver are “safe havens”, the financial parachute that investors and traders use during a crash landing.
But are they really safe? Are they still a good investment or just another bubble waiting to pop? You see, rather than blindly accepting what journalists and financial advisors tell us, we’ve decided to investigate these markets further, by using a more scientific approach called quantitative analysis.
The chart below displays the volatility fluctuations in gold futures over the last 2 years (January 2010 to 18th of April 2012). As you can see, there are two volatility estimators: close-to-close and the Yang Zhang estimator (“YZ”). The close-to-close is the volatility obtained by modelling closing prices each day. The Yang Zhang is the volatility extracted using high, low, close and opening prices and then weighted for the overnight risk.

 

There is significant evidence that the close-to-close volatility (left hand axis) tends to be higher than the YZ volatility (right hand axis). At first glance, we can observe that the average volatility for the market is 18% (for the close-to-close) while it drops to 7.5% (for the YZ volatility). By the way, the VIX averages around the 13%.

So what are these numbers telling us? Can we draw a verdict? Well, the overnight risk is greater than the intra-day one. In other words, gold prices are likely to experience big jumps from one day to another… and then trade within a narrow range during the day (everything else being equal).
And actually, we saw this last summer when we had a big price spike in gold… while the equity markets were getting crushed. And believe it or not, the volatility rose as gold prices were increasing.
Wait…What? But isn’t volatility connected to market crashes? Doesn’t volatility mean only confusion and uncertainty?
The quick answer would be” yes” but the correct one is “it depends”.

Sure, volatility tends to explode during market crashes. And, this type of relationship is called asymmetric effect (or leverage effect), and it’s particularly strong in equity markets.
However, in currencies and commodities the dynamics are a lot more complicated. You see, there is a tendency for volatility to pop as prices go up. Now, at this point, it’s a typical feature, not only in the gold and silver market, but also in the Swiss Franc, Japanese Yen, T-Bonds, German Bunds and other government debt securities…just to name a few.
Here’s something else.
The chart suggests that the volatility in gold futures is mean reverting. Therefore, it will tend to collapse towards its long term average over time. This, of course implies that short volatility strategies can profit… if kept on long enough. On the other hand, long volatility strategies can potentially be profitable if entered when the close-to-close volatility touches the 10% level or when the YZ volatility is trading around the 4% threshold.
It’s important to note here… that volatility is dynamic. What’s worked in the past or is currently working now does not mean that it will continue to work. And as always, past performance is not indicative of future results.

Moving on. What about the Silver?

The chart shows some similarities with gold. For example, we did see an explosion in volatility last summer as silver prices were increasing. Now, if we analyze the difference amongst the close-to-close (left hand axis) and the YZ (right hand axis) volatility, we’ll find a pattern which we saw earlier from the gold market. Once again, the overnight risk is greater than the intra-day moves.

As you may know, the silver market is extremely volatile… a lot more then the gold market. In fact, the average close-to-close volatility is around 40% (left hand axis) while the YZ volatility fluctuates around the 17% level.

And actually, like gold, silver volatility tends to be mean reverting.

Also, last summer, the close-to-close volatility touched 85% …in July 2011 and November 2011 it touched 100%. Of course, long volatility strategies would have been pretty sweet had you put them on before these big moves.

Finally, we’ve looked at both markets individually; it’s time to look at them together.

Closing Thoughts:

1) The silver market is twice as volatile as the gold market.

2) Overnight risk is big, the majority of the large movements occur overnight…not intraday.

3) The volatility is mean reverting in both markets and it follows a symmetric effect (it increases with buying pressure)

4) The volatility in gold is smoother.

Strategy Analysis: For Option Traders


Now, these are not trading recommendations, but a basic guide under the present volatility regime. Remember, volatility is dynamic and past results are not indicative of future results.

1) Long straddles or strangles are favourable when the realized volatility is around 20% for the silver and 10% for gold

2) Iron condors and butterflies positions are favorable when the realized volatility achieves the 35% – 40% for silver and 15% – 20% for gold.

3) Long volatility strategies are favorable when kept for a short period of time.

4) Short volatility strategies may take up to a month and a half to show consistent returns.

5) Call options tend to benefit from a one-two punch. When the futures price rises, implied volatility tends to rise with it.

In this report we tried to provide a quantitative approach to trading gold and silver using realized volatility data. Of course, there are many ways you can trade them and other factors to consider.

 

 

 

2 Responses to Trading Gold & Silver: A Realized Volatility Approach

  1. This is an excellent analysis of two very important instruments and furthermore the excellent writing style has made a complex subject understandable. Bravo!

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