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A Breakdown of GVZ by Mark Sebastian

by contributor on 04-20-2011 07:24 AM - last edited on 06-15-2011 09:44 AM by Administrator

On April 12th, the GVZ finally began trading.  While it has not come running out of the gate with huge volume, my hope is that eventually the product will take off.  I simply feel it is too good of a product to not do so.  There are too many traders involved in Gold for this not to drum up some interest.  I thought traders might be interested in a breakdown of how the options appear to have been priced.

 

The Futures:

Like the VIX, GVZ futures (a bet on the forward value of GLD volatility) appear to be in contango the majority of the time.  For those unfamiliar with contango it is a phenomenon where a back month future is trading at a higher price than a front month future.  In the S&P 500 futures this exists when interest rates are at higher levels.  In VIX and GVZ contango exist because the perception of volatility in the future is greater than the current volatility in the market place.  If the VIX is a fear gauge then one way to put contango would be: we are more afraid of more distant future than the immediate future. 

 

Unlike the VIX, the contango in GVZ futures does not appear to be nearly as strong as contango in VIX futures.  Today, for instance, May VIX future is trading at about a 3 point premium to cash.  GVZ is only trading at a premium of about 1.20.  The months following are around 1 point higher successively.

 

The Options:

The options opened with an IV around 65% in the front month.  Relative to historical volatility, this is a touch higher than the trailing historical volatility of GVZ cash at just about every measure of distance: 10, 20, 30 or 60 days.  However, since this is based on movement in the futures, NOT the cash, I expect HV will be much lower in the GVZ futures as volume increases. 

 

Like VIX, the term structure is such that implied volatility in back- month options is lower than implied volatility in front month option.  This is also likely due to perceived realized volatility in back month forward volatility (say that 5 times fast).  Essentially, since the back month futures are not going to be seeing as much movement, there is little reason for these options to have as high of an implied volatility as the front month.

 

Like VIX the GVZ has a forward skew or commodity skew.  This is because of its perceived use, the market maker in the product is assuming that traders are afraid of volatility going up in gold and thus will try to hedge against a rally in GVZ.  Traders that use GVZ to hedge will be buying calls and selling puts to collar rather than the traditional collar where one would buy puts and sell calls.

 

While the volume is light, traders are going to have to ‘work’ orders if they want to get any type of decent execution.  With that in mind when the options opened I bought a May 16 call to see how tough it would be to get a fill.  The market makers filled me at less than .10 above the mid price, not bad for a brand new product.

My initial perception of the product is that for retail traders looking to play GLD volatility, it will likely make more sense to play at the money (ATM) options rather  than out of the money(OTM), for now..  It appears that OTM options are a touch “over priced” in general.  This leads me to want to sell call spreads, buy butterflies, and when bearish, buy puts out right rather than try to sell a call credit spread. 

 

Before entering in any type of GVZ option trade I would strongly suggest that traders read the white paper, what the options trade, and maybe even paper trade a touch.  I would also warn traders that like VIX many broker platforms are pricing the options off of the cash instead of the futures, thus any IV you are looking at is essentially worthless.

 

For those interested in learning to hedge GLD against GVZ in the same way many traders use the VIX as a hedge against S&P 500 trade I will be writing about this subject frequently on my blog.

 

For more information about GVZ, please visit www.cboe.com/GVZ

 

 http://www.optionpit.com/blog

 

Comments
by rrhoads on 04-20-2011 08:58 PM
Options

Nice GVZ overview and we're thrillede to have you helping out with the VIX Class at the CBOE on May 7.

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About the Author
  • Mr. Bittman is the author of two books, Options for the Stock Investor, (McGraw-Hill, 1996), and Trading Index Options (McGraw-Hill, 1998). He teaches courses for public and institutional investors, and he has presented several custom courses throughout the U.S., Europe, South America and Southeast Asia. In 1980 Mr. Bittman began his trading career as an equity options market maker at the Chicago Board Options Exchange. From 1983 to 1993, he was a Commodity Options Member of the Chicago Board of Trade where he traded options on financial futures and agricultural futures. Mr. Bittman received a BA, magna cum laude, from Amherst College in 1972 and an MBA from Harvard University in 1974. In addition to his responsibilities at The Options Institute, Mr. Bittman is also a member of the faculty of The Illinois Institute of Technology, where he teaches in the masters level Financial Markets and Trading Program.
  • Mr. Kearney began his long association with the CBOE when he became an independent Market Maker in early 1981. Mr. Kearney traded options full time on the trading floor until 1992 and periodically thereafter until 1996. In early 1992 he became a founding partner and Registered Options Principal of a brokerage firm based in Chicago, a member firm of the CBOE. Mr. Kearney’s responsibilities included development and implementation of hedging and trading strategies using listed options for their institutional clients as well as their retail investors. Mr. Kearney is the co-author of Understanding LEAPS®, published by McGraw-Hill, September 2002. He has been a regular contributor to many news services including Reuters, Derivatives Week, BARRON’S, CNBC, Bloomberg, Group W, The CBS Radio Network, FORTUNE, Ticker Magazine, Stock Futures and Options, BBC TV and Radio, NPR, and others. Mr. Kearney served on various committees at the CBOE, including the Arbitration Committee from 1984 to 1996. Prior to joining the CBOE Mr. Kearney was a marketing director for NCR Corporation. Mr. Kearney is a graduate of St. Mary’s University (MN), BS, 1971, and pursued his MBA at Lake Forest Graduate School of Management. In 2006 he completed a 3-year SII/SIA program at the Wharton School of the University of Pennsylvania.
  • Peter B. Lusk is an instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange. He teaches option courses for public and institutional traders and has contributed educational type articles to various financial publications. Peter has spoken to thousands of investors across North America the past few years including over 200 webinars for the CBOE and member firms on trading options. He can also be seen each week on CBOE-TV with his show, Strategy of the Week. In addition to his responsibilities at the Options Institute, Peter serves as an Instructor for the Options Industry Council – an organization representing the options industry in the U.S. Prior to working at the Options Institute, Peter was a highly successful market maker for many years on the floor of the CBOE trading equity options. He was also involved in options training for new market makers at Lakota Trading in Chicago. As a professional trader, Peter enjoys sharing his knowledge of proven option strategies and risk management at the Options Institute.
  • Russell Rhoads, CFA, is an instructor with the Options Institute at the Chicago Board Options Exchange. He joined the Institute in 2008 after a career as an investment analyst and trader with a variety of firms including Highland Capital Management, Caldwell & Orkin Investment Counsel, TradeLink Securities and Millenium Management. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies. Since joining the Options Institute he authored Option Spread Trading: A Comprehensive Guide to Strategies and Tactics which was released in January 2011 and recently finished work on Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Traded Notes which was published in August 2011. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois – Chicago and acts as an instructor for the Options Industry Council. He is a double graduate of the University of Memphis with a BBA ('92) and an MS ('94) in Finance and also received a Master's Certificate in Financial Engineering from the Illinois Institute of Technology in 2003.
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