The trading industry naturally asks, “What are all the compelling economic factors underpinning commodity volatility?” Volatility is defined as price swings caused by new information entering the market. This might be an inflation forecast, an economic upheaval, or a miners strike for gold. Of course, absence of information or confusion about buyers and sellers might generate price swings.
For example, an uncertain political crisis. The resulting price movements put business or investment holdings at risk. So the trading community must consider both the impact that volatility on a specific asset class and how volatility overflows across asset classes.
Volatility has increased during the last twenty-five years. To name a few, greater globalisation and tendency toward economic integration, rise of developing market economies, rise of market-driven economies, technology advancements in trading, and increased usage of hedging instruments. Volatility has become an investment vehicle in itself due to heightened market instability.
The trading community must grasp the impact of fresh information on prices and use it rationally to their trading positions. What is the correct function of volatility trading, especially for asset types like commodities? What value does volatility trade add to the investor or trader’s portfolio? To address this critical question, a trader must comprehend volatility’s economic relevance. The role on volatility as a strategy diversifier is closely tied to information (or lack thereof) about other assets.
For example, gold price volatility can impact the equities, fixed income, & currency markets. Gold is a currency proxy. Price swings need reassessing inflation, deflation, and currency risk. Stock and bond markets, for example, would benefit from knowing more about currency and inflation dynamics.
Volatility tends to correlate negatively with price in the equity markets, i.e. market declines tend to correspond with high volatility. This is because stock value cushions corporate debt levels. During a share price slump, the loss of that cushion reinforces creditworthiness concerns. This causes increased stock market selling & volatility. This is why the VIX volatility is termed the “Fear Index”.
The gold market behaves differently. In many respects, gold is a shelter from political and economic turmoil. Currency (particularly the U.S. Dollar) weakness, inflation, and world events tend to raise gold prices. As a result, gold volatility is far more mixed than the stock market. Price and volatility can climb together. A good example is the 2008-2009 financial crisis. The Dollar fell and inflation expectations rose as the US economy slowed. So did gold’s price and volatility. The acute banking crisis of 2011 had such a different outcome. As Europe’s economy sank, the dollar strengthened and gold prices declined, even as volatility surged. Unlike stocks, gold volatility trading can be irrelevant to price levels.
In terms of volatility, there are also spillover effects between asset classes. Prices of financial assets like stocks and physical assets like gold respond to new economic figures. For example, news about overall inflation tends to affect both wheat and gold prices, albeit in opposite directions or magnitudes. Two reasons. First, new economic data will likely affect all markets, causing them to review price. Second, this information may prompt traders to rebalance typically consists to portfolio gains and losses, resulting in cross asset comparatives on volatility rather than price.
Markets have historically traded volatility. Many options techniques use the difference between projected and actual volatility. The most common are “straddles” (purchasing a put and a call option at same strike price & expiration). In this example, a rise in volatility would put the call option in the money. The option contract would be profitable if the market fell sharply.
Other ways to trade volatility exist. Like straddles, strangles require a both call and then a put position. The contract price of a call option is usually greater than the put option. This position is usually cheaper, but requires a bigger move in base prices to profit. A “butterfly” strategy involves buying that out call (or put) and selling 2 calls in between. In this instance, fewer dramatic market movements profit it. Each one of these options methods incorporates changes in price direction as well as volatility. In general, option volatility strategies must be rebalanced periodically to maintain a pure view.