Signal du Jour - long vol in SLV

Like Powell, Sharpe Two remains data dependant.

Yesterday, the combination of inflation numbers in the morning and the FOMC meeting in the afternoon resulted in fireworks in the stock and bond markets. A new all-time high was reached during the session, with rates coming off as the perspective of inflation cooling off (or at least not increasing) grew stronger. There is now an almost guaranteed rate cut in September, but the Fed will remain data-dependent.

So are we.

Sharpe Two is, first and foremost, a data-driven publication (apologies for the no-show last Tuesday—those following us on Twitter know we faced a data outage). And with the VIX at 12, mining data to find good options to sell will be more complicated. Could we find gold on the long side, then?

Today, we analyze the prices in SLV, the ETF that exposes investors to silver prices. When we take a long volatility trade, we typically keep it as a tactical hedge. Not this time. Let’s have a look.

The context

The performance of precious metals in 2024 has been stellar. Gold has added a solid 12%, while silver is already up 25%. Even though stocks have been delivering their fair share of healthy returns so far, this is something that can’t be ignored by those chasing alternative returns.

The reason behind this impressive start of the year?

It's hard to tell, and we are certainly no experts, but there seems to be a bit of a paradox. Precious metals are not supposed to perform well in a high-rate environment, yet they are doing well. Is it in anticipation of a rate cut? Is it because people think of it as a hedge against inflation? Could it be because central banks are driving prices up while rebuilding some of their stock? We’ve read the wildest theories and, more than ever, have no definitive opinion.

One thing is for sure: the realized volatility in these products has been slightly more elevated than usual, in line with some of the wild swings we’ve observed since the beginning of Q2 2024. It’s been trading at the high end of the range observed over the past three years. The move in the last few days has been particularly pronounced, catapulting the realized volatility above 30%.

Realized volatility has been jumping lately.

Once again, it is hard to find a solid justification as to why, but we are not here for that. Instead, let’s compare the realized variance term structure over a few periods to see how similar things are.

Could we be in a new regime for precious metals?

What is striking is that we are noticeably higher than the values observed in Q3 2023 when the market was getting anxious about the rate trajectory, and even much higher overall compared to Q3 2022, when fears of recession and hyperinflation dominated the marketplace. Could it be that we are simply in a different regime in the precious metals market and may stay there a little longer? It is possible.

In conclusion, it is indeed possible that the options prices do not reflect what is currently happening in the underlying and may be underpriced.

Let’s have a look.

The data and the trade methodology

Let’s start by understanding where the implied volatility in SLV has been trading over the past few months. We compute the variance swap at 30 days using options mid-price.

IV is not significantly higher than RV.