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Trading Gold Volatility Skew

Amidst all the geopolitical uncertainty, GLD is seeing a breakout. This breakout is coming in spite of dollar strength, and the move looks even stronger when denominated in euros. This is coming off the back of another 1T in stimulus from the EU, and concerns about currencies across the board seem to have everyone piling in gold.

GLD options volatility shows us how this fear to the upside can happen. What we can do is look at the implied volatility of GLD options versus strike price and see how OTM options are being bid higher:

This chart is the GLD volatility smile from about a month ago. This looks at the implied volatility across the GLD options board. The different colors are different months, and the x-axis is the strike price of that option. These charts come from LiveVolPro. We can see that OTM options generally carry a higher relative bid as investors are willing to pay up a little more for a strong event. This smile is different than the normal "skew" we see on equity options, as investors generally don't pay up for OTM calls. This shows how the underlying sentiment is different in gold vs other asset classes.

This is today's GLD volatility chart. You can see that ATM options (the lowest point) have a higher premium relative to a month ago-- but that's not the important part. The volatility smile has steepened. The red line is the front month options and you can see how the call implied volatility is starting to get a little out of hand. This is due to the uncertainty in greece and a fairly strong technical breakout in GLD.

Now I personally think the smile is a little too steep. So the way to fade the smile steepness is to sell OTM calls and buy ATM or less OTM calls. This is known as a ratio spread. So take this for example:

Buy 10 Jun 123 Calls

Sell -20 Jun 126 Calls

By doing this you are selling the vol on OTM options and buying vol on ATM options. Here's the risk profile:

This trade has limited reward if GLD tanks, and unlmited risk if GLD rips higher. So this is a contrarian bet and it ties up a lot of margin and risk. You could modify this and go into a broken wing butterfly, but your reward on the downside gets limited. You could also vary the strikes to get the optimum premium and vol risk you want.

The main point of this trade is to look for the implied volatility curve to flatten. So the options you sell should lose premium faster than the options you buy.

This is just a trade idea and not a recommendation. If you like the way I setup trades, consider subscribing to my trading service. Many trades come with an educational aspect like this-- but the trades are much more simpler than this one!

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/