No matter your strategy, a solid understanding of the relationships that exist across positions in your portfolio will help you better manage your risk exposures. It can also help you build new market assumptions for deploying capital.
While some of this knowledge is acquired through experience and market awareness, traders can conduct due diligence prior to entering unfamiliar positions.
For example, let's say that a hypothetical trader believes gold price movement will be relatively muted in the wake of the US Federal Reserve's recent decision to raise interest rates. This market assumption may be built on the expectation that the next move by the Fed won't be until June 2017.
As a reminder, the value of the US dollar is highly correlated to interest rates. Generally speaking, as interest rates increase in the United States, the value of the US Dollar also increases, and vice versa.
Going one step further, the US Dollar and the price of gold tend to be inversely correlated - as the price of the US Dollar increases, the price of gold tends to decrease, and vice versa. The historical inverse relationship between the value of the US Dollar and gold is illustrated in this chart.
Bearing all of the above in mind, we can further infer that as interest rates rise (which should theoretically catalyze a strengthening US Dollar), then gold prices should go down.
Looking at price data in the US Dollar and gold over the last year, which includes two interest rate hikes by the US Federal Reserve, one can see that the price of gold has indeed dropped, while the value of the US Dollar has risen.
Going back to our earlier example, let's say that prior to the US Federal Reserve meeting in June 2017 (the next expected rate hike), a hypothetical trader expects movement in the price of gold to be relatively muted.
The trader might have built this market assumption because he/she believes that the Federal Reserve won't act before June, which might further indicate that an interest rate event won't occur prior to June. In turn, this suggests that the value of the US Dollar could trade relatively flat alongside gold. (It should be noted that other economic developments could affect the value of the US Dollar in the interim.)
A recent episode of Options Jive dovetails nicely with the sample market assumption built above. The main focus of particular segment is an overview of the correlations that exist between commodities and their associated ETFs.
In fact, one of the commodities covered on this episode is gold, the focus of our sample market assumption. Using data from the last year of trading, the correlation between gold and its associated ETFs are shown below:
As you can see in the above slide, the price of gold is most closely correlated to the GLD, but the GDX and GDXJ aren't far behind.
Consequently, a hypothetical trader holding the assumption that gold prices may be relatively muted over the next couple months could analyze the respective Implied Volatility Rankings (IVR) of GLD, GDX, and GDXJ to ascertain whether an attractive short premium trade exists in any of these products.
If a trader had alternatively built a market assumption in crude oil (or another commodity), a similar analysis could be conducted on USO, XOP, XLE, and OIH. The correlations of these oil-related ETFs to crude oil are also included in the aforementioned episode of Options Jive.
If you have any questions about correlations between commodities and their associated ETFs, or building a market assumption, we hope you'll reach out at email@example.com.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.