FMX Connect Explains Today's "Comical" Gold Move To Near Record Highs

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Submitted by FMX Connect

Connect Gold Options Report – July 12, 2011

Summary

August Gold settled at $1562.30 per troy ounce, a gain of $13.10 for the day.

Market Recap:

Gold opened the day firmer on continued European sovereign concerns. The euro was weaker, the dollar was stronger and gold made new highs in Euro terms. As it did six months ago, the first time the Greek crisis was unveiled, gold is now competing with the dollar for safe haven status.

Tuesday saw Irish government bonds downgraded, debt ceiling negotiations deteriorated, and the curtain lifted on the June 22nd FOMC Minutes. This statement was most notable for its consideration of additional quantitative easing, contingent on economic conditions. This news was enough to spur gold higher, taking out the congestion area that had been giving it such a hard time.

We think what’s happening is almost comical. Most Western governments are in a race to the bottom to get their currencies as low as possible. This is an attempt to cheapen their debt by debasing their currencies. Every time the dollar spikes it must make Bernanke pull the hair he has left out of his head. Every time the euro weakens the Fed does what it can to strengthen it. One way is by opening swap desks with the European banks to give them all the dollars they need. Another way is to say the magical phrase QE3. While the timing of this news is in many respects a coincidence (because the minutes are released weeks after the event) we do recognize that Western economies must devalue their debt. We are in a race to the bottom and the euro is winning, hence the rally in gold.

Gold goes up for two reasons now. The first is obvious: gold is a dollar-denominated asset and as the dollar weakens it will increase in value. The second is sovereign or default risk, which is actually deflationary. Europe and the U.S. will continue taking turns driving gold higher with the Chinese chasing it all the way up.

Volatility was stable to lower with the market slightly higher in the morning. Options remained orderly while we stayed under the congestion in the 1557 area . Once we printed 1560 the landscape changed dramatically. Liquidity providers ran from bids, abandoned their markets and left OTC brokers cursing constant flakers. Skew and volatility both moved upward considerably. The volatility curve you see below is a representation of where volatility was at 4:00 pm and is in no way related to the settlement volatility that the CME generates.
 
Directional Commentary:

Options: Options told us to be bullish yesterday and they did not lie. It appears that volatility has legs to run now. There are approximately 27,000 lots of open interest at the 1600 strike in August. The majority of these purchases were initiated by a large hedge fund. We have to figure this option will come into play. One item that gives us pause is that the August 1630 Call and 1650 Call were sold near the highs, so someone may be expecting a pullback. So while that mitigates options’ bullish sentiments a little we’re sure that futures longs will be selling calls to create dividends at these volatility and skew levels. Conclusion: Bullish

Technical: Yesterday we said gold was looking for a settlement above 1556 before it began to break-out in earnest. Having eclipsed that level we are expecting a run on all-time highs, actually we are only a couple of dollars away. We expect this rally to make an attempt at 1600 and for the large open interest at this strike across the term structure to be a major factor. Large open interest at a specific strike is a cause for concern and even more so when a large percentage is in the hands of a few players and their counterparties are undercapitalized and fragmented; this is a classic recipe for a short squeeze in the option. In general the fragmented undercapitalized professionals are professionals who will buy futures in a rallying market to mitigate their adverse change in delta. The long isn’t hedging or selling futures to sell positive gamma, he wants his options to go in the money and has the pockets to be patient. Many times the mere size of the open interest and the fragmentation of the short-side counterparties creates the gravitational pull needed to go through the strike or at least to the strike. In this particular instance, we think the long is strong and that August gold will print 1600. Past that point, gold could try for the top of the trading channel. We become more neutral with a settlement below 1560.

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