Hedged a call with a call: Gold, Silver and USD etfs

[Cadavre]

Puts always seem over priced and calls typically seem cheap.

There's a Silver ETF (IAG) that is delivering despite the fact the USD index and Gold has been flat for a couple of days.

I traded into a Gold call (IAU) and hedged with a USD bull fund call (UUP). The gold call was relatively expensive. The UUP cost a dime (not much more than the cost to do the trade and there's a lot of Vol and Open Interest for the strike). However if the IAU goes south, the [very] cheap UUP call will pay off in spades according to my forward spot pricing software. If I loose half my IAG premium the UUP call will pay back double the cost of IAU call.

Essentially what I did was hedge the pricey IAU call with an embarrassingly cheap USD bull fund call. The CBOE has chains for all those guys.

 

[Martinghoul]

How do you know your hedge is, in fact, a hedge? What if gold and the dollar both head south? Moreover, what's the point of hedging a call option in the first place?

 

[Cadavre]

I hedged the IAU call because the hedge was cheap (10 cents) and because I want to keep as many of my pennies as I can in my little brokerage account.

UUP (bull) calls behave as a hedge for IAU calls. I've been looking at them for a while. When IAU goes up, UUP goes doen. When IAU goes down, UUP goes up. I couldn't help but assume there's an inverse correlation.

I am trying to keep as many pennies as I can. If my IAU hunch fails, I hope to make up the loss through an anticipated gain (based on a forward spot convergence model) from the UUP. I don't expect to recoup all if my hunch is wrong.

Do you know that it is not a hedge? Why is it not a hedge? Isn't there a inverse relation of USD to gold, of USD to the DOW (for now)? When USD is strong - gold is cheap. When USD is weak, gold is expensive. When USD advances, DOW declines. When USD falls, DOW advances. Without a major restructuring of US monetary policy, the obvious expectation is that is the way it will be (right?). We live in a world where there seems to be an inverse relation, therefore a hedge correlation, between the USD and gold. They both cannot fall together (can they?). They [have to?] travel in opposing directions.

US Stocks are pricing in Euros. In 2002 .80 USD exchanged for 1 Euro. Today 1.50 USD are required to exchange for one Euro. In 2002 300$ was equivalent to 1 oz gold. Today, 1150$ is equivalent to 1 oz gold . The DOW, as well as gold demonstrate an inverse relation to the dollar:

Let's compare UUP (bullish dollar) with IAU (comex gold ishare):
UUP:

IAU:

* note : if we were to stretch the 1yr UUP out to the width of the 1 year IAU, we'd see something akin to an inverted 1 yr IAU - I could not find a similarly formatted UUP chart.
Gold:

Now let's compare the USD Index to the DOW:
USD Index:

DOW:

* note : it almost seems that if we were to flip the 1 Yr DOW upside down that we'd have a chart that looks very much like a 1 Yr USD Chart.

Here's what the loss for the IAU call will look like should IAU decline. HV for IAU is 14.37%. IV for this call is 26.62%. The ATM IV for this expirations is ~23.50%.

Here's what the hedge will payoff should the USD advance and Gold Decline (starts today and shows single day time steps - HV is 14.37% - IV is 15.27%). At 10 dollars a contract it's pretty cheap insurance for IAU - makes a penny pincher feel good!

Are these inverse relations? What kind of relation other than an inverse correlation should be used to develop a hedge? I will be first to admit I'm no maven - so anything you might offer would be appreciated!

 

[Martinghoul]

I am not suggesting your reasoning regarding the correlations is wrong here and now... I just think you need to be aware of the fact that the correlation you're currently observing doesn't have to hold in the future. The dollar and gold can both sell off. You have to realize that gold/$ is just another ccy pair. So the position you're running is essentially: long gold/$ vs long $/basket (57.6% EURUSD, 13.6% USDJPY, 11.9% GBPUSD, etc). So just think about what happens when gold declines against the basket? As to the Dow vs USD, the dynamic of the correlation are different and the influence of the dollar is not direct.

Finally, whenever you mention UUP calls being cheap, it's sort of a meaningless statement without knowing the strike.

 

[Cadavre]

Is there a basket etf that will provide a hedge that might be more useful?

I am looking to hold these guys for a while. Yes, I'm a buy and hold shopper - at least until I can grow my pool - but first I have to hold on to as much of it as I can. Multi year charts seem to argue market doldrums around this time of year with a breakout after the first.

The Vol shown for the UUP 25$ Mar call [today] is 501 - the Open int shown is just over 19,000. What should that information be telling me - does it mean a bunch of UUP share holders are just trying to get a bag of change before Christmas by writing calls that will never exercise?

 

[Cadavre]

Finally, whenever you mention UUP calls being cheap, it's sort of a meaningless statement without knowing the strike.

To a rookie like me it means they don't cost very much.

Here's a snag of of a UUP chain I parsed earlier today. The green highlighted symbols I think indicate that the IV is below the HV (and I have no idea as to how that is interpreted). There's a another pair of columns not shown that compare the IV to HV price (don't know why that is done either unless it's used for another feature in the program that asserts forward prices as a function of hedge ratios and expiration (don't know what that means either). The left most column indicates call put parity (but I don't know how to take advantage of that data either). The ZP (after the IV) indicates that the bid was zero. You can see an option box at the top that is selected to price the bid. The S:X is the Stock price to Strike ratio and is used for hedge ratio pricing as alternative to closed form and speed/decay models (see the snag in my earlier post). The other side of the straddle, the puts, can be seen by scrolling right. I have not traded puts yet.

Can you spot from the information in the image what you know to be cheap calls and help me understand why they might be cheap?

 

[Martinghoul]

Is there a basket etf that will provide a hedge that might be more useful?

I am looking to hold these guys for a while. Yes, I'm a buy and hold shopper - at least until I can grow my pool - but first I have to hold on to as much of it as I can. Multi year charts seem to argue market doldrums around this time of year with a breakout after the first.

The Vol shown for the UUP 25$ Mar call [today] is 501 - the Open int shown is just over 19,000. What should that information be telling me - does it mean a bunch of UUP share holders are just trying to get a bag of change before Christmas by writing calls that will never exercise?

Your hedge depends on what particular view you're looking to express... At the moment, given your position (I don't know the sizes, so this is a guess), your trade is expressing a view that gold will appreciate against a basket of currencies. Is that the risk you like and want to keep? If so, you don't need to hedge anything... On the other hand, if your view is that gold will appreciate against the $, you have your gold calls. If the calls are too expensive (i.e. they have too much delta), sell a bit of the underlying, instead of doing something that's an indirect hedge, at best.

EDIT: In response to your question about cheap UUP calls, I can see what all these things mean. Ultimately, however, it's a matter of judgement what you think is cheap vol vs expensive vol. Moreover, the most important question is what your objective function is. What exactly is the reason you want to buy calls rather than the underlying outright?

 

[Cadavre]

What exactly is the reason you want to buy calls rather than the underlying outright?

First Martinghoul, thanks for giving my post attention.

Equities seem more like expensive low return derivative bets. It seems pretentious to think that these times offer an underlying asset of any real value. I hoped to show in those charts that a DOW is little more than buying a short against the dollar. The mainstream "financial news" outlets have as much as admitted that.

Look at the US financial sector - they've all been bailed out - been paying large bonuses - and reluctant to pay back the trillions they've received from the taxpayers (sounds more like a deadbeat than a producing business to me). Yet today the value of their equities went up. How can that be - there's almost zero business - the consumer is on the sideline and these negative interest rates the market makers (or breakers) are getting from the FED ain't being passed to small business. Infact, despite the 0 rate from the discount window, consumer credit (cards) are pushing near 30%!

They say it's a jobless recovery - that's just another way of saying there's no one in the store - no money in the pockets of the masses means nothing is except beans and rice is being traded - and Wall Street don't sell beans and rice - so why pretend the underlying is anything more than a derivative?

My challenge is limited to cash. I can't buy on the margin. I have to grow the seeded cash I have. 4 weeks ago, IAU stock was a little over 104$. The April 115 call was 3.60$.

I could have purchased 3 shares of IAU stock for the same price as one April 115 call. Wind forward, IAU stock is marketing at a little over 113$ and the April 115 Call is 6.60$.

The open to buy close to sell ROI for the Apr 115 call was 300$. Selling the 3 shares that could have been purchased for around the same price it took to open the Apr 115 Call would have netted about 27$. The option delivered 300$. The equity would have delivered 27$!

Does that make sense?

The only problem I have with my limited fund challenge is that I cannot move in and out of a position as fast as I would like. THe old buy and hold. I have to research a lot. As long as the fake DOW and Goldman's front running dark pool parlor, the NYSE, are a short dollar play, the only opportunity I see are derivative asset bets that offer an inverse correlation to the USD. I really think the US banking system is trying to kill the dollar. When it's dead, DOW assets will as useless as lips on a parakeet!

Metal is obvious - I am a rookie - so that's where I look. I know there are start up technologies like IR solar technology and LREN (cold fusion) that are interesting ground floor equity bets - but they'll have to wait.

Do you have any opinions on the direction of the USD and what kind of plays might offer the most bang at a bargain with a quick return for the least risk (I bet everybody is asking that question)?

 

[Cadavre]

EDIT: In response to your question about cheap UUP calls, I can see what all these things mean.

Is a cheap call a NTM or ATM strike with a higher HV than a DITM strike?

 

[Martinghoul]

Is a cheap call a NTM or ATM strike with a higher HV than a DITM strike?

I don't know what NTM means... Generally speaking, ATM options always have the lowest vol. Deep ITM strike call = far OTM strike put, which implies that vol for the strike will be higher.

As to whether the comparison of current IV to HV actually provides insight into the richness/cheapness of the option, that's the $100mm question. Remember that HV is based on the actual observed volatility of the asset during a specific historical period. IV, on the other hand, tells you the mkt's consensus regarding the future volatility of the asset from current date to expiry. Is an analysis based on comparing current IV to HV valid? Should you expect volatility going fwd be higher or lower than the volatility observed in the past? I don't know... That's why trading is, ultimately, an art, rather than a science.

As to your big picture, macro questions, I have my views. I am happy to share them, if you like, but you have to be aware that they are nothing more than opinions. Fundamentally, at the moment, I don't like to be short $, since it's a very very crowded trade.

 

[GladiatorX]

I don't know what NTM means... Generally speaking, ATM options always have the lowest vol. Deep ITM strike call = far OTM strike put, which implies that vol for the strike will be higher.

As to whether the comparison of current IV to HV actually provides insight into the richness/cheapness of the option, that's the $100mm question. Remember that HV is based on the actual observed volatility of the asset during a specific historical period. IV, on the other hand, tells you the mkt's consensus regarding the future volatility of the asset from current date to expiry. Is an analysis based on comparing current IV to HV valid? Should you expect volatility going fwd be higher or lower than the volatility observed in the past? I don't know... That's why trading is, ultimately, an art, rather than a science.

As to your big picture, macro questions, I have my views. I am happy to share them, if you like, but you have to be aware that they are nothing more than opinions. Fundamentally, at the moment, I don't like to be short $, since it's a very very crowded trade.

Also OP; ' Cheap ' Options are just a perspective and opinion...
an OTM option may be cheaper than an ATM; but not a bargain for example...
You get what you pay for;
However you may identify, on your criteria, that an option is cheap Vs what you think is its true market value...

As for IV/HV in qualifying an option...
As Martin has said; its the $100m question.
I've viewed some research which has found that IV is more accurate than HV - Therefore in terms of identifying a cheap option it may be better to look at the IV's relationship to price/option price historically for each individual option rather than assuming on the whole... For example, you may find areas where the IV is 'Oversold' and usually reverts to its mean; In which case you may see it as a 'value' or 'cheap' option.... Because historically when IV is at such levels it has risen...
Therefore assuming that the market opinion of volatility is lower than you expect = Bargain (If you are correct).
Like everything in trading; there is no certainty;
... Is IV/HV relationship relevent... You'll have to find out. Because its not a 'fact' one way or the other.

 

[Cadavre]

I don't know what NTM means...

Again, thanks for responding.
Apologies for taking liberties with an acronym license. NTM was meant as Near The Money, or not quite ATM (at the money).

EDIT: I miss typed my question:
When I asked: Is a cheap call a NTM or ATM strike with a higher HV than a DITM strike?

What I really meant was:
Is a cheap call a NTM or ATM strike with a higher IV than a DITM strike?

 

[Martinghoul]

Again, thanks for responding.
Apologies for taking liberties with an acronym license. NTM was meant as Near The Money, or not quite ATM (at the money).

EDIT: I miss typed my question:
When I asked: Is a cheap call a NTM or ATM strike with a higher HV than a DITM strike?

What I really meant was:
Is a cheap call a NTM or ATM strike with a higher IV than a DITM strike?

It's extremely unlikely that an ATM or near ATM strike will have a higher IV than the deep ITM strike. Frowns are very rare in the mkts.

 

[Cadavre]

It's extremely unlikely that an ATM or near ATM strike will have a higher IV than the deep ITM strike. Frowns are very rare in the mkts.

How about a "snear"? - Sneers seem to appear at the DITM position on the short side of the strike

Regarding the expensive verses cheaper I think I generalized to much. For example:

The stock is at 100$. The 105$ call has an IV of 23% while the 110$ call has a 21% IV. IOW, the call strike furthest from the money is priced at a lower IV. The usual expectation is the strike closest to money should have the lesser IV.