Now Is a Good Time to Consider an Oil / Gold Pair Trade

When making recommendations in my weekly newsletter EPIC Insights, I have always been wary of our risk profile. The portfolio has done extremely well during sell-offs and rallies and I have no interest in surrendering gains by blindly diving into untested ideas. For that reason, one of my favorite approaches is to construct a pair trade. By being long of one instrument and short of another, we eliminate market direction and trade the basis between the items.

With pair trades, you look for two items that should trade in the same direction yet have experienced a temporary dislocation. By betting on an eventual return to normality, pair traders will make money regardless of the direction the market takes.

As commodities, gold and oil share many similarities. Both are negatively correlated to the U.S. dollar, offer a hedge against inflation, and perform well when investors seek hard assets. Over the last three years, these two items show daily price movements that are highly correlated to one another. All the similarities point to an expectation that as prices move up and down, the relationship between gold and oil should remain relatively static.

However, there are a few key differences that cause the prices of oil and gold to diverge. Gold has little industrial use and is seen as both an inflation hedge and a store of wealth. Oil is an industrial commodity that sees its price fluctuate based on economic expectations. These differences take what should be a static long-term relationship and offer tremendous short-term volatility. Within the shorter movements is where I seek opportunity.

The easiest way to examine the price of these items is through the gold/oil ratio. Over long periods, the ratio is very steady. Since 1983, the ratio has averaged 15.7 (15.7 barrels of oil were needed to buy one ounce of gold). Currently the ratio stands at 13.1-well below the averages seen in the last decade and even over the last 25 years.

We initially traded these items on April 20 as we shorted gold and purchased oil when the ratio stood at 17.6. As expected, the economy began recovering as the massive monetary and fiscal stimulus took effect. This drove oil higher on demand factors and took gold lower as fear subsided, making our trade very successful.

Just as this normalization was expected, we should not be surprised that the trend has moved too far in oil's favor. For now, the market expects the economy to experience a V-shaped recovery and the Fed to prudently remove excess reserves from the banking system. I am skeptical on both fronts. With growth subdued and the likelihood of the Fed breaking under mounting government pressure, I expect oil to decline and gold to regain its shine. Such events would drive the ratio from today's 13.1 toward the long-term average of 15.7.

For retail investors, this trade would have been impossible to do a few years ago. However, the advent of ETFs now allows us to position for the move. As a proxy for oil, use the United States Oil Fund (USO). For gold, use the SPDR Gold Trust (GLD). Expecting the gold/oil ratio to decline, I recommend a long position in GLD and a short position in USO as this week's fundamental trade.

Note: At the time of this article, I am short USO.

Comments

[sharpe_mind:]

I have this trade on too. It's not as compelling an opportunity as back in September last year, but it still makes a lot of sense right now.

Sep 02 08:43 AM

[LoveShorting:]

Thanks, Sean, you're a good teacher. I also like pair trades, but where I go long best of breed and short a lesser competitor as long as the
former isn't over bought and the latter under priced. In this case, I
won't touch oil, too volatile, but I am about to grab a little GLD since breaking above $95 was my entry signal

Sep 02 01:11 PM

[HardwoodFlo...:]

Investment Advice: Leave commodities to the pros...

Sure stocks will correct 7-10%, people will go back to their commodity ETFs and push commodities & Gold (the price) up. Then, things will relax and normalize people will start rotating out of their commodity stuff around late september and around mid October and equities will move upward, steadily not crazy, until the end of the year (all the fund managers have to keep theri jobs ya know) getting back the 10% they lost in the first two weeks of September. But what the hell do I know...

It's nice to see a normalization of the markets so that they are so predictable. I can't wait until people start talking about "holiday" travel, the end of "hurricane season" and all the other stupid stuff they propogate to move markets on a short term basis.

Folks, it's back to the future. Funs over. Sorry. Now people are going to have to start talking about IPOs and companies that actually make products. Those poor dumb bastards at Fast Money on CNBC are all going to have to find new jobs. They will be replaced by an "IPO Expert" and an "M&A Guru". Wow, people might actually start taking about things they know something about. Instead of "buy the rips sell the dips".

As for gold, if it breaks out of $1000 that means that they are letting the suckers in...Get ready for it to drop, and I mean seriously after that.

I hate to say it but has any one on SA spent a day in the pits? If you're not in the game, you're out of the game. If you're not in the know you're out of the know. If your not the smart money you're the dumb money. In the 70s more dummies got cleaned out in the pits than any Madoff scandal. to me this looks just like the same thing- history repeating itself....But what do I know...

Sep 02 11:07 PM