Gold Options: Intrinsic Value Curves (The Basics)
This post is a quick tutorial on an analysis tool commonly used on this site having to do with gold options and their intrinsic value curves. It can be used as a reference for both new and seasoned investors in the gold market.
To start off, their are two types of options:
Put-options: These contracts give the buyer the option to sell the underlying reference gold futures contract at given strike-price on options-expiration day. For example, if you were to buy a put-option with a $2,000 strike-price and the underlying futures contract was trading at $1,970, your put-option would be said to be ‘in-the-money’. Its intrinsic value in this case would be $30/oz (i.e. $2,000 - $1,970) multiplied by the 100 oz which is the contract unit size. In other words, the intrinsic value of the contract would be $3,000. On the other hand, if the underlying gold futures price was trading at or above the $2,000 strike-price then the put-option’s intrinsic value would be zero or ‘out-of-the-money’ because you would not want to exercise your option to sell at a lower price than you could get in the market itself.
Call-options: These contracts give the buyer the option to buy the underlying reference gold futures contract at given strike-price on options-expiration day. For example, if you were to buy a call-option with a $1,950 strike-price and the underlying futures contract was trading at $1,970, your call-option would be said to be ‘in-the-money.’ Its intrinsic value in this case would be $20/oz (i.e. $1,970 - $1,950) multiplied by the 100 oz which is the contract unit size. In other words, the intrinsic value of the contract would be $2,000. On the other hand, if the underlying gold futures price was trading at or below the $1,950 strike-price then the call-option’s intrinsic value would be zero or ‘out-of-the-money’ because you would not want to exercise your option to buy at a higher price than you could get in the market itself.
For every contract month, there is an ever-changing distribution of put- and call-options that are outstanding for each possible strike-price. This is called the open-interest which can be shown as a distribution like in Figure 1. Looking at the $2,000 strike-price call-options, for example, we see its open-interest is 6,179 contracts which is the quantity of option contracts outstanding at that strike-price.
For each contract, there is both a buyer (long) and a seller (short) the contract. The buyer of the option wants to see the intrinsic value of the contract go up while the seller, who would have to payout that intrinsic value on expiration, would rather it do the opposite and go down or better yet, expire worthless so they will not owe anything.
If one were to take all the call-options outstanding for a particular contract month and calculate what collectively their intrinsic value would be for each strike-price, the result would look like Figure 2. As price of the underlying rises, more and more of the call-options outstanding will become ‘in-the-money’ and thus have a larger intrinsic value. This is why the intrinsic value of call-options increases with price.
Similarly for put-options but with the opposite result. Since it gives the buyer of the put-contract the option to sell at a predetermined price, as price of the underlying falls, more and more of the put-options outstanding will become ‘in-the-money’ thus increasing their collective intrinsic value. This is why the curve in Figure 3 increases as price declines.
Adding the intrinsic values for both puts- and call-options together for each strike-price (i.e. the green- and purple lines) results in the intrinsic value curve for ALL options outstanding for that particular contract month. This is shown as the red-line in Figure 4. The strike-price associated with the minimum or lowest point in the parabola is referred to the ‘max-pain price’ because it is the price that will deliver the smallest possible return (or maximum pain) collectively to the buyers of the put & call options. Conversely, this max-pain price for the buyers of the options will be the maximum-benefit price for those collectively who are short or who have sold the options.
In the example being presented, the intrinsic value (IV) minimum or max-pain price is $1,880 which is associated with an intrinsic value of $175 million. Now suppose the underlying price were to be trading at $1,970 which would imply an intrinsic value of $355 million. The difference between these two or the delta-IV is $180 million ($355 - $175).
Since it is a parabola, there are two strike-prices on the intrinsic value curve that can give a delta-IV of $180 million; that is the already mentioned $1,970 price as well as $1,790. Figure 5 is presented to help visualize this.
Everyday, due to the buying and selling, creation and destruction of put and call options, the distribution outstanding is always changing. In some cases, one can see this reflected as a shift in the intrinsic value curves as shown in Figure 6. For example, the shift in the left-slope of the parabola to the right (or higher in price) can be associated with the distribution of put-options moving higher in price. Similarly, a shift of the right-slope of the parabola higher in price can be associated with the distribution of call-options moving higher in price. One can refer back to Figure 2 and 3 to help visualize this.
During a period where price trades range-bound within a large consolidation pattern, (like 2021 to 2023), the delta-intrinsic value at expiration will tend to cluster around the intrinsic value minimum. We can see this in Figure 7 which shows the delta IV values at expiration for all contract months going back to 2019.
Empirically, around 65% of the prior 28 contract months since the Dec’20 contract have expired with a delta intrinsic value of $40 million or less. This increases to around 80% if the delta intrinsic value is widened to $75m or less. In other words, if the underlying gold price were to make an excursion well above the $75m delta-IV level early or mid-month, the odds would favor a convergence lower in price going into options expiration at the end of the month.
Figure 8A-D shows four historical examples of this. The red-line (right-axis) shows the delta-intrinsic value while the bars (left-axis) shows the price-premium or -discount to the max-pain price for each trading day leading up to options expiration. In each instances, delta-IV becomes extended to the upside (i.e. above $75m) and then trends lower going into options expiration (which is the farthest right date on the chart).
There are also instances where price does the opposite and actually closes at maximum divergence from its intrinsic value minimum. When this happens, it is kind of like a short-squeeze since it forces the sells of the options to buy or sell the underlying in order to hedge their short options position thus creating a positive feedback on price. Figure 9 shows an example of this with the Oct’22 contract. In this case it expired at its highest delta-IV at option-expiration.
For a broader perspective, Figure 10 shows the prior 27 gold options contract months in a single chart. In the top half, the gold price is shown along with the daily max-pain price-levels while in the lower-half, the daily delta-IV values are shown on the right axis along with markers signifying the level at options expiration.
So far we have been examining contracts that have occurred while price has traded range-bound within a consolidation period such as 2021 to 2023. However, during a transition period when price transits from one consolidation level to the next, monitoring these delta-IVs becomes less useful because the rapidly advancing price leads to a different paradigm where high and erratic delta-IVs are normal. Notice the completely different character in Figure 11 which shows the year 2020. The right-axis scale was tripled to account for the larger swings.
Who are the main traders in gold options?
Every week, the CFTC publishes its Commitments of Traders Futures-and-Options Combined report. In order to combine futures and options into one report, the options are converted to a futures-equivalent using a conversion factor (i.e. delta-factor) as explained below by the CFTC. By backing out the futures-only data using the Disaggregated Commitments of Traders Futures Only report, an option-only data set can be derived.
Figures 12 & 13 shows the distribution per category group for both longs and shorts when viewing gold options through the lens of their futures-equivalent. It shows that around 80% of the positions outstanding can be categorized as spread positions meaning the trader is holding both a long and short futures-equivalent position in options. Commercial traders which generally include the ‘Producer’ and ‘Swap-Dealer’ trader categories, only account for about 25% - 33% of positions outstanding. The largest category group is the ‘Other’ trader.