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Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

Fed Beneficiaries Getting Soaked on Gold Futures Options

Commodities / Gold and Silver 2010 Nov 11, 2010 - 02:29 AM GMT

By: Dr_Jeff_Lewis

Commodities

The largest beneficiaries of rampant quantitative easing and destructive monetary policy are those who can borrow at the most wholesale level of the financial system.  Those who have access to the discount windows and emergency windows are doing quite fine, borrowing money and dumping it on the markets to benefit from record low rates and quickly growing inflation levels.


However, those same institutions that were cleaning up in negative real interest rate conditions are now getting their clocks cleaned as a result of ignoring the obvious: rates are too low.

Generating Income on Futures

The biggest investors in the world all come together on the futures market where they speculate, gamble and “invest” in paper deliveries of some of the most important commodities and stock indexes.  Many of these institutions, in light of record low interest rates, borrow capital, invest it in a popular commodity future (net long on inflation), and then write covered futures options to generate an income.

This strategy normally works out quite well.  Commodities rise slowly in times of negative real interest rates, and the futures owners can write covered calls so far away from the current price that they clean up at expiration.  Now, though, they're not cleaning up.  If anything, they're heavily underwater.

What Happened?

Just two months ago, in September, the options on gold futures with strikes in the mid $1300s were selling for less than $20. Those who had long positions on the paper markets could essentially sell bets against their own holdings, or write them completely naked, and generate a return of just over 1% in less than two months.

With rates as low as they are, that 1% looks mighty appealing, since gold is likely to run up with inflation.  Of course, the mid $1300s weren't so obvious in September, so it seemed that whatever income the institutions brought in would be pure profit.  It wasn't.

In fact, anyone who wrote those calls lost lots of money in potential upside from gold.  Considering this is a very popular trade, especially among institutions and major players, we can only imagine how many millions of dollars in potential earnings were lost by the big boys and handed to the small time option players.  Judging by the near 15,000 contracts in open interest, in September no less, we can imagine that quite a few big boys lost their shirts.  Those who were already naked, selling options against non-existent holdings, felt the pinch to an even larger degree.

Futures Karma

After years of investment bank theft in the futures market, it is at least enjoyable to some degree to see their long time games backfire in their faces.  Their persistent short interest (this time, neutral interest) left them holding monumental losses.  Here's to hoping that they've learned their lesson – that it never makes sense to be net short or even market neutral when the Fed is against you.  Of course, the Fed is usually a teammate, but this time it proved to error on the side of “friendly fire.”

By Dr. Jeff Lewis

    Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of Silver-Coin-Investor.com and Hard-Money-Newsletter-Review.com

    Copyright © 2010 Dr. Jeff Lewis- All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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