Volatility Skew in Gold
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In a few paragraphs that everyone is expecting to appear in his annual letter, Warren Buffett recently explained why gold is fundamentally a greater-fool, unproductive investment. That theme of productive and non-productive assets got me thinking over the weekend, and Joe Weisenthal picked up on some of my comments on Twitter about gold and the rigorous misanthropy of many of its loudest proponents.
I know some people love to hate "fiat money" and any fiscal policy that smacks of "kicking the can down the road." What I've noticed after talking to many self-described proponents of Austrian economics and "hard money" is that often, barely under the surface, is a desire for some kind of eschatological settling of accounts, in which the evil get what they deserve and society collapses into dust, leaving only the survivalists and their precious metals to thrive in the new, purified world. Let's leave the not-so-latent theology and politics of that sort of view to one side.
What I want to think about here is the empirical fact that there are plenty of people with this attitude: people who are happy to buy the gold bars that Glenn Beck is was selling, who will forego years of real returns from productive assets in the hope that they will someday find a buyer at a higher price for that otherwise useless metal. Goldbug demand is real demand, and to the extent that some metals enthusiasts care about the nominal value of their assets in real time, they will be inclined to hedge that nominal exposure using options. They are natural longs, and so will act just like equity longs where options are concerned: buying puts, selling calls, and thereby creating the familiar downward volatility skew. (I should mention, polemic aside, that I also think there are legitimate scenarios where it makes sense to own gold - but in hypothecated, tradable form, and not for decades without end.) The attached chart from Livevol Pro shows the skew for SPDR Gold Trust(GLD) options expiring in January 2014.
GLD Options
There are also natural gold shorts: everybody else in the world. That's why gold options traditionally have traded with volatility skew on the upside as well. Derman noted this in his well-known "Laughter in the Dark" paper in 2003. Gold looks like a safe place in a crisis, and everyone knows that, which is why the order flow is willing to accept higher implied volatilities at higher strike prices.
The result: a genuine volatility smile or smirk, with much higher implied vols at both extremes. There are always real-world explanations for financial phenomena, whether or not those observations can also be explained mathematically.
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At the time of publication, Jared Woodard held no positions in the stocks or issues mentioned.
