The Price of Gold Insurance

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"The options market can teach us something about risk."

The options market can teach us something about risk. Options comprise a risk transference—or insurance—market. A put option, for example, gives its owner the right to sell the underlying asset at a fixed, predetermined price during the life of the contract no matter it actual market value. Similar to car insurance, you're "putting" a suddenly devalued asset to the insurer for cash compensation when you make a claim on a policy.

The premium of the insurance cover is risk-based. If you tend to crunch vehicles, you're considered a bigger risk, thus your premium is higher.

Likewise, put option premiums inflate when traders perceive greater downside risk. Look what happened to put options on July 27 when COMEX gold tumbled $25oz.. The price of a December SPDR Gold Shares Trust (GLD) put 10% out of the money the day before was $1.67/share. After the price break, the insurance cost with a 10% "deductible" ballooned to $1.92/share. The risk of a "claim" clearly increased.

To determine if the increased risk perception is specific to the gold market, compare changes in gold ETF options to those of similar puts on a competing investment (e.g., the SPDR Depository Trust). The cost of a 10% out-of-the-money SPY contract was $3.44/share July 26 and $3.38 on July 27. Divide the premium of GLD by that of SPY to see the market's changing option of gold risk. On July 26, gold insurance was priced at 48.6% of that for the stock market. A day later, the cost had climbed to 56.8%.

Gold's rebound from last week's lows brought down the insurance cost but not to pre-break levels. The insurance cost ratio is a sentiment indicator, useful in quantifying market risk without requiring anything more than basic arithmetic.

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