Stocks Are Plunging – Is Gold The Right Hedge?

Gold & Silver, Options, Volatility

When the stock market does its best impression of a swan dive, it tends to come from an unexpected catalyst. It’s generally not something about interest rates or corporate earnings or jobless numbers. Those factors matter over time, but they don’t usually cause sudden, severe moves in the market.

No, very large selloffs often come from a source that many investors didn’t see coming. That’s the way of things. Surprises can exacerbate the problem of course. It’s clearly easier to prepare for negative news if you see it on the horizon.

While the world was aware of COVID-19, the coronavirus, the U.S. markets have not paid all that much attention to it. There was a small pullback in stocks earlier in the year, but the market quickly recovered. It wasn’t until the virus hit South Korea, Japan, and Italy hard that the financial markets finally became concerned.

And concerned they definitely are. As I write this, the S&P 500 is down nearly 7% in two days. VIX, the volatility index, hit 30 this week. That’s a level we haven’t seen since the late December selloff in 2018.

Related: Trade of the Week: E-Trade Financial

It seems the stock market finally realized the major disruptions that COVID-19 may cause to the global supply chain and business activity in general. We know major Chinese cities have virtually shut down. What will the virus do to the rest of the world?

The full impact remains to be seen. Even if the rest of the world is able to slow the spread of the virus the economic consequences will be felt regardless. You can argue that US markets should have seen this coming, but that ship has sailed. Now the question is, what’s the best way to protect your portfolio?

A popular hedge in times of a crisis is gold or other precious metals. Gold has been a store of value (essentially a form of currency) for thousands of years. So, it’s no surprise that market participants are quick to buy the metal when stocks start plunging.

But is gold really the best way to hedge?

The problem with most assets, including gold, is they tend to all correlate in times of panic. Investors will sell off everything they own in order to go to cash. Or, traders may be forced to liquidate their winning positions in order to cover margin calls on losers. Either way, it can cause even precious metals to drop (which is actually what happened on the second day of the selloff this week).

Still, there are clearly those who believe gold is the path forward. In fact, a massive amount call spreads on SPDR Gold Shares (GLD) traded this week. These were opening positions and they clearly look like they are betting on gold going higher by early March.

The person/fund who made this trade bought two huge blocks of call spreads expiring on March 13th with GLD trading at $155. The 160 calls were purchased while the 165 calls were sold (to reduce the cost of the trade) for a total of $0.60. This is known as a bull call spread and it traded a total of 75,000 times.

For those of you keeping track at home, that’s $4.5 million premium spent on the trade which makes money above $160.60 in GLD by March 13th expiration. The max that can be lost on the trade is the premium spent. On the other hand, the position can generate $4.40 in profits, or $33 million, at max gain at $165 or above.

Clearly, someone with massive resources is bullish on gold for the next couple weeks. This is also the type of trade you could easily execute in your own account if you believe gold is going higher. It’s not always the best hedge, but in this case, there is definitely at least one prominent believer in the yellow metal.

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