Golden Spread: XAU vs. Futures

02/07/2003 12:00 am EST


Lawrence McMillan

Founder & President, McMillan Analysis Corporation

Comments from our readers have shown that gold is among the sectors about which they wish more information. Many readers have also expressed an interest in options. Here, we combine both--an options play on gold.  We note, however, that this article is for those familiar with these complex markets and we caution against speculating in areas in which you are unfamiliar.

"There has been a lot said about how well the gold stocks have been performing," says Larry McMillan, editor of The Option Strategist. "At the same time, owners of gold stocks might just be wondering what all the fuss is about. For example, December Gold futures are up from 315 to 360 in the last month or so. At the same time, the gold and silver index ($XAU) is up from 62 to 74. As percent gains go, the $XAU seems to be outperforming–a 19% gain vs. a 14% gain. However, that is illusory. For if we measure the moves in standard deviations, which is the proper way to measure such things, then we incorporate volatility–the facet of performance that is often (incorrectly) ignored. The 20-day historical volatility of Dec gold futures is 15%. The 20-day historical volatility of $XAU is 40%–quite a difference. That means that $XAU is supposed to advance quite a bit farther, percentage-wise, than the gold futures when both are trending as they are now. Specifically, then, gold futures have risen about 3 standard deviations while $XAU is up only about 1.5. That is quite a discrepancy and is why there have been some articles about how the gold stocks are lagging.

"Usually, when we see something like this, we consider using an intermarket spread–if there is an extreme relationship between the two entities. The chart above shows the 8-year history of $XAU divided by the price of Dec gold futures. On that chart, when the ratio is low (i.e., when the graph is near the bottom of the page), gold stocks have been under-performing. When the ratio is high on the graph, gold stocks have been out-performing. Since the ratio is quite low on the graph now–albeit not at the lowest point–that indicates that gold stocks are generally underpriced with respect to the price of gold. Part of the reason for this condition having lasted for the past few years is fundamental–many of the gold companies have had disappointing earnings due to their penchant for selling their product–either with futures or forwards–at what turned out to be lower than market prices. We don’t really care about that, however. What we are really interested in discerning is whether or not the graph can move back to the levels it reached four or more years ago. While no one can know for sure, it seems feasible to set up a hedged position with options that has a chance to profit if either 1) gold stocks begin to outperform gold futures, or 2) if both markets make a substantial move in either direction. The second way to make money evolves out of the fact that we are using options in the position, so one side has limited risk while the other side can make large profits.

"We are suggesting an options play on the XAU vs. gold futures.  Our recommendation is to buy 3 XAU June 70 calls and 2 June gold 380 puts. This represents a to tal debit of $9600 or less.The 3-by-2 ratio takes into account the different prices and volatilities of the underlying instruments. In theory, the entire $9600 is at risk, although in practice gold stocks and the price of gold tend to move somewhat in concert at most times. Profits would be made if the ratio climbs to 28 or if the prices of the underlyings both risesubstantially or both decline substantially."

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