Going for the Gold

The decline in the dollar and the low interest rate environment are clearly affecting asset prices globally. Capital is fleeing the dollar and flowing everywhere else. While gold has certainly been a beneficiary of this technical rally (price chart at right), its rise has been built on reasonable fundamentals and real demand.

While gold may seem to be structurally overbought (perhaps thanks to the margined prop desks and other carry traders?) there may be some near-term opportunities to build a stronger position. The thesis is as follows:

1. Since March, capital flowed out of risk-less and into risky assets

2. Foreign risk takers needed to hedge their USD exposure of these risky investments, thus exacerbating the dollars decline.

3. Risk has become fundamentally under priced in recent weeks (LIBOR-OIS spreads had dropped back down to pre-Lehman levels earlier this month).

4. Now, sentiment is beginning to shift back to fundamentals

5. We may see a technical pull-back with year-end window

dressing ahead

6. Given the lagged nature in changing correlation structure, the GLD-SPY positive correlation may be expected to hold during a short-term market correction. This will be an opportunity to add to a hedged position in Gold (vis-a-vis the GLD) that will benefit from the long-term macro picture in the U.S. and abroad.

Gold has continued to set newer highs in nominal terms with reasonable fundamentals (i.e., there is increasing real, physical demand for the asset).

Price action in the GLD underlying has been roughly in-line with the expectations given by

option prices, but in recent days, the volatility skew is suggesting increased put buying (see volatility analysis at right), which may be indicative of bearish sentiment in advance of a pullback.

Additionally, the CBOE's gold volatility index (GVZ) has been fluctuating between 20-30 since late August, and the spread between 20D HVOL of GLD and 20D lagged IVOL on GLD has not changed meaningfully in the past several weeks.

Most interestingly, since March, Gold has shifted polarity, becoming highly correlated with the S&P500 (SPY). From a ratio perspective, the GLD/SPY ratio is below recent historical highs.

I am keeping my eyes on theATM Dec-09 115 calls (expiring in 25 days), which have pulled back 22.3% since Monday's gap-open on the GLD (GS quote at $2.36). The ratio of 25d IVOL to HVOL is is in from the wides of 1.6x last week, now at 1.38x (21.26% iVol and 15.46% hVol, annualized).