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When fear strikes the markets…Gold and the Vix Jun 12 at 18:11 GMT

When fear strikes the markets…Gold and the Vix

Many forex traders approaching the end of their tethers with market uncertainty over the future of the euro zone, nibbling their nails and bashing at the buy/sell button at momentary intervals, will do well to remember that volatility can be a trader’s best friend.

The appeal of gold as a safe haven for beleaguered traders has resurfaced with vigour of late, with gold futures rising gaining by as much as 0.45 percent an ounce during US morning trade Tuesday. But there are other ways to protect your money amid stormy conditions.

Vix and the volatility lovers

The Chicago Board of Trade volatility index (Vix) is used as a measure of the S&P 500’s volatility. Along with others such as the HSI Volatility Index and the Hang Seng Risk Adjusted Series, these indices provide traders with a valuable measure of perceived fear in the markets. The Vix is driven by options trading and is calculated as a positive percentage, reflecting the expected volatility of the S & P 500 over the next 30 days.

Generally speaking, traders can expect to see the Vix trending between 15-16 points but any market nervousness is likely to push it higher. Yesterday’s generally jumpy conditions – which saw initial euphoria on a promised EUR100bn Spanish bailout deal fade to scepticism – saw the index pushed to 21 during the London session.

These options contracts give traders the right, but not the obligation, to buy or sell a specified amount of one currency for another at a specified price on a specified date. They help to provide an indication of the way in which traders perceive that the markets will move in the specified time frame. As banks and hedge funds start to see any indication of downside risk in the markets, they will begin to buy up options in order to mitigate risk; the higher the anticipated price swings, the higher the premiums charged by options writers.

Following the yellow brick road

As has traditionally been the case, the appeal of the yellow brick has succeeded in tempting investors away from currency pairs and into commodities amid the most recent currency storms. Gold is often seen as the strongest haven asset, with speculators placing unswerving faith in the purchasing power of the precious commodity as other markets rise and fall.

Just today, the World Gold Council released an amendment to a previous European central bank agreement, which will affect stocks until the date of 26 September 2014. The third Central Bank Gold Agreement reaffirmed that "gold remains an important element of global monetary reserves", as was stated in the two previous Agreements. But the collective ceiling was reduced so that "annual sales will not exceed 400 tonnes and total sales over this period will not exceed 2,000 tonnes".

And yesterday’s market activity stands a testament to the increasing appeal of gold; growing concern over the potential for Spain to recover from its fiscal illness and on growing fears that Italy – or for that matter Cyprus – saw gold futures for August delivery trading at USD1,604.05 a troy ounce during US morning trade.

The logical conclusion would be to presume that gold and the Vix share a strong bond, reflecting each other’s trajectory as volatility and uncertainty have investors running for safer alternative to currency trading. But, as Craig Dyke of City AM writes, “they seldom trend in line. The current structure of the Vix has existed for over 21 year, but over this time gold and the Vix have had a correlation of less than 5 percent with a standard deviation of 27.”

But there are times when generating an overall picture of sentiment using data from the two indicators can be a useful tool for a trader. According to Nicholas Colas of ConvergEx Group, “the real ‘buy’ signal for stocks is when the gold-Vix relationship begins to decline from its peak”, adding that there are occasions where the pair can display correlational strength of up to 76 percent.

Dyke adds: “Traders can use the Vix as a hedge against volatility in the S&P and in the equities market as a whole. With neither gold nor volatility set to plummet just yet, traders should keep an eye on the correlation between the two for an indicator of ongoing market sentiment and for signs that the market is reaching the bottom.”

Sarah Cox, Staff Writer


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