Gold Hits New High of $5,311. But Volatility Has Returned to High Levels? Next Another New High or Pullback?

TradingKey - During the Asian session on January 28, spot gold broke through the $5,200 and $5,300 milestones, hitting an all-time high of $5,311.68. Meanwhile, gold volatility has also risen significantly: implied volatility for Comex gold futures has surged to its highest level since March 2020, the peak of the pandemic, while the ratio of gold volatility to 20+ year U.S. Treasury volatility has climbed to its highest point since the collapse of Lehman Brothers in 2008.

Where is the high volatility in the gold market coming from?

According to Bloomberg, current options trading is primarily concentrated in call spreads: nearly 5,000 lots of April Comex gold $5,500/$5,600 call spreads have been traded, while a more complex $5,500/$6,000/$6,500 call option structure with a 1x3x2 ratio expiring in April has seen nearly 1,000 trades. These strategies signal that traders are convinced gold will breach $5,500 before the April expiry, though the $6,000 target remains an enticing yet high-risk bet.

Call spreads on SPDR Gold Shares are also being snapped up. The market purchased nearly 70,000 contracts of the $590/$595 spread maturing in September and 37,000 contracts of the $510/$515 spread maturing in March. Strategists at Susquehanna International Group noted that, using the March contracts as an example, if the fund rises by 10.1%, the maximum return could reach 4.2 times the principal. As of the close on January 27, the fund was priced at $476.10.

Notably, as traders expand their long call positions, market makers who sell these calls must buy more gold futures contracts to hedge their exposure. This accelerates the rise in gold prices, creating a short squeeze driven by the "gamma effect."

As traders engage in a frenzy, option pricing models dictate that the surge in demand will drive up the implied volatility of gold futures and funds.

Does extreme volatility signal a correction from current highs?

Extreme market movements typically trigger market concerns. Current gold volatility not only reflects aggressive trading but its ratio relative to bond volatility has also climbed to its highest since the 2008 Lehman Brothers collapse. In September 2008, the Lehman failure sparked the worst global financial crisis since the Great Depression of 1929; this ratio essentially embodies market distrust of U.S. Treasury credit and a mania for gold.

When this ratio peaks, it manifests as overbought on technical indicators and suggests that risk-off sentiment has reached its zenith in terms of market psychology. At that point, gold prices could face a sharp correction, similar to the precedent set in 2008.

Furthermore, even if gold prices do not fall in the short term and merely trade sideways, a rapid decline in implied volatility will lead to a significant contraction in option premiums. In other words, as expiration approaches, every day of sideways movement increases the probability that gold will fail to reach its target, causing the value of contracts held by traders to erode. Once the contract value breaches psychological support levels, it could trigger massive forced liquidations, prompting market makers to sell futures contracts and transmitting correction pressure to the gold market.

In short, a correction from these highs is logically possible for gold. However, in practice, Wall Street remains generally bullish on the outlook for gold prices.

Ole Hansen, Head of Commodity Strategy at Saxo Bank, stated in a report that while safe-haven demand for gold may have begun to cool, a sharp correction is unlikely in the near term. Currently, gold allocations for many institutions remain low and far from being overcrowded; global central banks continue to purchase gold, and the macroeconomic factors supporting the rally remain unchanged—namely, concerns over U.S. debt and lingering questions regarding the Fed's independence.

However, he also believes the risk of a prolonged consolidation for gold is rising, as the market needs time to digest current overbought sentiment and elevated implied volatility.

Jan Skoyles, Head of Marketing at British precious metals dealer GoldCore, views the gold rally as "exceptionally calm and fairly methodical." Although corrections will occur, gold always "finds buyers again quickly and bounces back from a higher base." She believes this indicates that the market views gold as a long-term allocation rather than short-term speculation.

Wall Street is even continuing to bet on higher prices. Deutsche Bank on Tuesday raised its year-end gold price target to $6,000 per ounce, a 28% increase from its previous forecast. This projection aligns with that of Société Générale.

Morgan Stanley (MS) stated this week that gold prices could climb to $5,700 per ounce in the second half of this year, while Goldman Sachs (GS) expects gold prices to reach $5,400 per ounce in December, up from its previous forecast of $4,900 per ounce.