The drop in gold and silver in the past few days has been quite breathtaking. Some might say unprecedented, but anyone with enough experience in financial markets knows that asset prices have always made disjointed moves. And what the media rarely acknowledges is that assets often make such moves in the absence of news, not because of any catalyst.
There is one main reason why gold and silver have fallen so quickly in the past 2 days. Simply put, they hit sell stop orders at massive long-term support levels. One quick look at the 5 year weekly charts of gold and silver futures shows how they have broken their multiyear support levels:
I certainly didn’t expect such a fall. I knew those levels were important, but also expected them to hold in the short-term. However, the speed of the move is a good demonstration of how quickly prices can change. It’s also a demonstration of compressed volatility.
What do I mean by compressed volatility? In short, volatility for all asset classes has been trending lower for the past 18 months. I write a weekly “Vol Around the World” note that assesses implied volatility levels for global asset classes. I have mentioned my surprise for months now that implied volatility for commodities has not ticked higher despite the price weakness we have seen to start the year. Gold and silver are grabbing the headlines today, but oil, copper, and grains have all made big moves as well.
Compressed volatility describes an environment where traders anticipating volatility have not been rewarded for months or years, and traders anticipating low volatility have been rewarded. That creates a feedback loop where traders making the biggest bets are placing more money on low volatility strategies, while few traders are placing money on increasing volatility. At some point, the low volatility bus gets too crowded, and one major price dislocation causes disjointed price moves.
Given the volatility environment over the past 18 months, this feedback loop has compressed volatility across all major asset classes. Commodities are the first to break from it. I do expect 2013 to be more volatile for all asset classes though, and when environments of compressed volatility break, they don’t often do so in a gradual manner. Escalator up, and elevator down.