Silicon Investor (SI) -- The First Internet Community

STOCKTALK

We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor. We ask that you disable ad blocking while on Silicon Investor in the best interests of our community. If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.

Politics : Idea Of The Day -- Ignore unavailable to you. Want to Upgrade?

To: IQBAL LATIF who wrote (29074)	9/30/1999 9:31:00 AM
From: IQBAL LATIF	Read Replies (1) \| Respond to of 50167

The Reason Behind the Impressive Rally in Gold??Delta Hedging 9/29/99 10:06:42 AM Sometimes the open interest configuration of an option series can yield powerful insight into how the underlying stock or commodity may move in the short-term. In particular, when a large amount of open interest resides at an out-of-the-money strike, the underlying issue can be drawn to this level as market participants are influenced to hedge naked positions. This phenomena, known as delta hedging, helps explain the impressive rally in gold over the last week that has left some market watchers scratching their heads. Gold was a candidate for a delta-hedging rally due to the heavy amount of call open interest that resided at a couple of previously out-of-the-money strikes. (Options on the December Gold Futures contract are being used for the purpose of this discussion.) Note in the table below the relatively heavy accumulation of open interest at the 270 and 300 strikes. As long as these call positions remained well out-of-the-money, those who were short these calls had little incentive to hedge their positions. However, an uptick in the underlying instrument, in this case the spot price of gold, can influence these shorts to hedge themselves by purchasing gold. The more gold rallied, the greater the pressure becomes for those who are short the calls to hedge. The net result is often a sharp rally in the underlying to the strike price that is the site of the heavy call open interest. Once the strike price is reached, the rally may stall, as now all market participants are likely hedged. Now those who are short the calls have the incentive to short the underlying stock or commodity to prevent the options from finishing in the money. However, external market forces are sometimes so great that the stock or commodity breaches the strike by a significant margin. In this instance the underlying instrument is poised to rally explosively, as the call writers face additional pressure to hedge themselves. This appears to have been a contributing factor to the sharp rally in gold on Monday and Tuesday. The graph below is a daily chart of the December Gold Futures contract (GC/Z9). Note that the rally that began on September 21 brought the large call positions at the 270 strike significantly closer to being in the money. The writers of these options were likely unhedged, as the options were previous well out-of-the-money, and gold had shown little ability to rally over the past few months. As these traders hedged themselves by buying gold, the rally in the commodity continued to pick up steam through the end of last week. It is also interesting to note that the futures contract closed Friday back below the 270 level. Remember, once the strike was achieved, the bears now had the impetus to keep gold below 270, so the call options would not move in the money. Attempts to keep gold under 270 were thwarted by Sunday's news that 15 European central banks have agreed to limit their gold sales over the next five years, as well as freeze their level of gold lending. Gold futures gapped higher in Monday's trading en route to finishing the day higher by $14. The December 270 calls were now well in-the-money, and the writers of these calls were forced to hedge by purchasing gold thus adding fuel to the fire. Tuesday's trading saw more of the same with the yellow metal busting through the 300 level, that was the site of approximately 14,000 contracts of open interest at the close of Monday's activity. December gold eventually moved as high as $329 per ounce before moving lower to close at $310 per ounce. While delta hedging was not the primary reason for the rally in the gold, it does appear to have been a contributing factor to the explosive move to the upside. - Jeremy Rehm (jrehm@sir-inc.com)