Algorithmic and Mechanical Forex Strategies | OneStepRemoved

Spotting Pivots in Gold Prices

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Gold is hard to predict. Often, when it seems to be gearing up to a bearish momentum, it stops and flips. It also often looks highly bullish only to melt down and carry the bulls with it. Of course, this kind of uncertainty is an inherent part of trading, especially when it comes to gold. This means you have to invest more effort in spotting the possible breakouts and pivots that enable us to plan our trades. In this article, we will focus on how derivatives can help you discover accurate pivots in gold prices.

Gold Prices Through Derivatives

The real problem with gold is that it can fall or rise quickly, without warning. That makes it hard to spot opportunities for those who trade it as though it’s a forex pair. However, those out-of-the-blue rapid movements are, in many cases, closely tied to the derivatives market, where most of the gold trade takes place just like any other commodity. In one of my previous articles about implied volatility, I demonstrated how derivatives can help you monitor volatility relatively easily. But what about pivots? You guessed it: derivatives – or, more specifically, option prices on the CME – could be rather handy in that respect, too. How? By showing us at what price most bets are concentrated.

Using Option Analytics on Gold

Below the CME Option Analytics illustrates the puts (short) and calls (long) options open on gold at any price. The orange columns are puts, and the blue ones are calls – in other words, sellers versus buyers. The vertical red line in the middle is the current price. Now, what does this mean and how the hell can it help us spot pivots? Very simple. All the orange columns (puts) on the left of the red line (current price) are short bets waiting for the price to fall, while all the blue columns (calls) are long bets waiting for the price to fall.

As can be seen on the 1,100 price, the short bets are overwhelmingly higher than the long bets. This leads to a rather straightforward conclusion: if the price of gold crosses below the 1,100 level, it will immediately trigger a pile of short options and trigger a strong bearish wave, marking a very important pivot we should watch from. If you are long on gold, a break below 1,100 might be a sign to bail out, while if you are a short seller, you might want to wait for gold to cross below 1,100 for bearish momentum to accelerate.

Of course, this is a mirror of what might happen on the right side of our price, where at 1,150 there are piles of call options waiting for gold to rise above. As you can see, this is way lower than the pile of puts below 1,100 but it’s still significant and makes our upper pivot.

On the left side of the red line (options below our current price), if the number of call options was much higher than the puts – lots of bullish bets at 1,100 – it would pin down 1,100 as a strong support zone. Of course, once again dynamics on the left side (above current price) would be the mirror of this. This so-called screen is essentially the CME order book – just like when you look at your own account on the buy and sell orders, this illustrates the buy and sell options of the entire CME exchange on gold and for us. This means we can see where the broader market places its bets and sees pivots, and plan our next gold trade much better.

 

The World of the VIX

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The VIX, or Volatility Index, is among the most watched indices in the world, certainly on the CBOE (Chicago Board of Exchange), with most traders checking it at least once a day. Unlike most indices, the VIX’s price is not comprised of stocks or bonds. What the VIX measures is volatility around the S&P500 index using options.

 Why Bother with the VIX?

As mentioned, the VIX measures the volatility around the S&P500 index, or more accurately, the implied volatility around the S&P500 index. You might wonder, “What’s the difference?” Implied volatility is expected volatility, and since in trading tomorrow is the present, that difference does matter. As an index, the VIX is relevant whether you are trading FX, commodities or equities, but it holds a special significance if you trade the S&P500. That’s because the S&P500 is the most tradable (and traded) index in the world with most major asset classes having some level of correlation to it.

When the VIX rises (i.e. becomes volatile), in most cases, it suggests investors are nervous, not just in equities, but across the board. That is why so many investors often refer to the VIX as the “fear index” (my personal favorite, by the way).

In fact, one of the most dominant trades since the 2008 financial crisis is what investors call risk on/risk off. That means markets are primarily trading based on broad risk appetite. For example, when risk appetite is high, riskier trades (such as long equity indices or short dollar) tend to benefit. Simply put, the VIX measures implied volatility over a wide array of stocks. Because implied volatility generally rises with risk, the VIX is seen as a good barometer of risk on/risk off sentiment. The VIX is an important gauge of the market’s mood, whether you plan to counter or go with a trend. As you can see below in the chart (courtesy of V-Lab), the S&P500’s implied volatility and the VIX move almost in tandem.

VIX Chart

VIX: Under the Hood

The VIX is basically composed of the premium that investors are willing to pay for both call and put options on the S&P500. The average expiry date for those options is approximately 30 days and that tends to be when implied volatility is most indicative. The higher that premium, the higher the VIX will be. If we were to link back to the risk on/risk off trade, if investors are worried that risk is on the rise (which causes implied volatility in the S&P500 to jump) then the VIX simultaneously rises. When investors are calm, implied volatility falls and the VIX is lower.

There have, of course, been days when the VIX was rising and market was in risk on mode (and vice versa), but those cases are generally rare. Naturally, as a trader, you must always be aware that anything can happen at any time.

When to Use the VIX?

Now, here is the tricky part of the VIX; the VIX is what is known as a contrarian indicator. That means it is more useful as an indication of a risk of a change rather than an indication of the current trend. Behaviorally, the VIX can be likened to an elastic material; it always tends to gravitate back to balance. When the VIX is at record highs it tends to move back lower. When it’s recovered and hits a fresh low then it tends to move higher. While it’s important to always keep track of the VIX, as seen below, the extreme levels can suggest if the market is in a risk on/risk off mode. When the VIX is at record highs, it might be time to trade on a risk on mode. Why? Because market jitters are likely to wane and therefore risk related trades (i.e. long AUD, EUR, GBP, SPX, etc.) might be the wisest trade. Naturally, the opposite also (generally) holds true.

VIX RangeSource: CBOE

VIX has Cousins

Among all of the indices that measure volatility, the VIX is the most important, especially given the S&P500’s correlation with nearly every asset class. But what happens when you want greater accuracy or more relevance to your current trade (e.g. Forex, commodities or other global Indices)? While the VIX may be the granddaddy of them all, there is a “family” of volatility indices linked to specific indices, asset classes and even to specific trades. For example, the OVX measures the implied volatility on Oil, while the EUVIX measures the implied volatility on the Euro. Can’t wait to meet the rest of the “family”?

Want to learn how to use other VIX indicators? Then stay tuned for my next article.

Volatility & Your Trade

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Picture this; you’re on the verge of opening a new trade. The indicators you’ve been patiently awaiting – averages crossing, RSI hitting 80, or whatever else – are finally moving into perfect alignment. You expel a huge sigh of relief and your order is engaged. But then, instead of the solid trend you were expecting to see, you get instead pretty much nothing. A market that is just barely muddling through. You’re dragged right into a stagnant market leaving you scratching your head and thinking, “what did I miss?”

It doesn’t make sense. You were diligent; you did your research and you calibrated your indicators and still you got nothing. No movement at all; just a range.  It’s frustrating beyond belief. And what about the times you set up that “great” stop loss that the market abruptly sliced right through. Does that scenario sound familiar? Sure. It happens to everybody.

So, what did you miss? In a word: Volatility.

The Wisdom of Derivatives

Of course, we all know about volatility; it’s the measurement of price fluctuations. Or more plainly, it’s how fast a price moves. It is volatility (or its absence) that entangles a pair within a range, often swiftly and mercilessly. And while the average spot trader may believe volatility comes at the market’s whim that is generally not the case.

In the spot market volatility may seem a force majeure, but in derivatives trading, volatility is the essence, especially with options. Generally, options trading is based on volatility and more specifically, on implied volatility. And implied volatility is the expected volatility as embodied in the price of the options.

Implied Volatility Made Simple

Before you begin to get stressed out, rest assured, this is not a lesson in options trading. Rather, it’s a lesson on how to predict volatility and use it in your trade. Implied volatility is the suggested volatility as extracted from the price of Put and Call options on a specific stock or currency pair. If you’ve no experience with options trading this might seem tricky. In fact, that couldn’t be farther from the truth. Thanks to volatility indicators we can measure implied volatility on various FX pairs.

The CBOE FX Volatility Index

The CBOE exchange, where many FX options are traded, is also where you’d find a convenient series of volatility indicators. For example, the EUVIX measures implied volatility on the Euro, the JYVIX does the same for the Yen, etc. Reading an index is simple; when the index is high, volatility is expected to be high and vice versaImplied Volatility Source : CBOE

Two Dimensions to Watch

When analyzing the volatility index for a specific currency there are two dimensions to consider. The first dimension is pretty straightforward; it is the level of the index. If the level is high or rising then you should take that fact into account. That’s especially important if you’re planning to place a rather small stop loss. The EUVIX (and its ilk) can help you understand what level of volatility currently exists under current market conditions.

The second dimension denotes the “zones” of volatility. That is if the index hits a certain level or zone it tends to either fall back or bounce. In the graph above, note that the EUVIX tends to ease around the 13-14 zone and rise around the 11-12 zone. Unlike the spot market, with volatility indices it’s more of a zone you’re aiming for, not an exact spot.

EUVIX_upSource : CBOE

How would you use a volatility index?

It’s a straightforward process. When the index approaches or is above the zone of maximal volatility, you can expect volatility to fall. In that case, if you’re riding a trend, prepare for some slowdown in momentum. Conversely, if the index is below the area of minimal volatility, it’s likely that volatility will rise from here onwards. If the pair is range bound and you’re waiting for a break that could be good news. Bad news could also be good news if it triggers a stop loss close to the market price. What’s important is that you will be cognizant of where to expect volatility. Also, understand that the maximum and minimum volatility areas change over periods. That means you need to watch how the index responded in a similar timeframe (hourly, daily, weekly, etc).  Of course, as well all know, nothing in this world is a certainty, least of all in the world of trading. Even so, monitoring volatility, both in the long term and short, is crucial for trading success.

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