Strong Signal From The Gold/Silver Ratio

| About: SPDR Gold (GLD)

Back in April, I took a look at the ratio of gold to silver prices as represented by the gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) ETF proxies. At the time, gold and silver had been whipsawed (mostly lower) and today, nominal prices as represented by the ETFs are even lower. In fact, the one year charts of the GLD and SLV are downright ugly.

Silver hasn't fared much better against a backdrop of more certainty on the part of market participants which leads to more risk taking. As gold is a proxy for fear and uncertainty in the marketplace, this type of environment is bearish for gold, all else equal.

Given that is the environment we find ourselves in, if you are interested in getting exposure to precious metals but you can't stand the 2%+ daily moves of silver or gold, what can you do? I like the GLD/SLV pairs trade because it allows you to get exposure to precious metals without having to simply accept the enormous moves the market sees in precious metals on a frequent basis. Just have a look at the chart above and see how many gap days there are and how many very long bars there are; these are indications of enormous moves in the price of the GLD and it is happening very frequently lately. Thus, the pairs trade strategy seeks to mitigate some of that noise and profit from a protracted trend in the relationship between the prices of two securities.

So what are we to do? Back in April, my chart looked like this:

Without rehashing the entire article here, the point I made was to say that gold had broken out of its channel against silver and that getting long gold and short silver in equal amounts had a reasonable likelihood of producing profits. In fact, here is what has happened in the roughly six months since:

Since the point where I mentioned the breakout of GLD in relation to SLV, the ratio went from six to about 6.7, indicating strong outperformance of gold over silver during that time period. Subsequent to that, silver outperformed sharply and the ratio fell back below six. Now, with the ratio right where was in April, I think we are poised for another period of outperformance for gold.

The chart pretty clearly shows that the bottom in the ratio for gold to silver, at least with current information, is around six. This trade worked out very well in April and I believe a similar trade can be put on right now for the same reasons. I also like the trade now because the spike in silver versus gold earlier this year has clearly ended, as you can see on the far right of the chart. With the overreaction done with and stabilized, gold is likely set to outperform again.

There are a few ways to take advantage of this relationship, should you be so inclined. You can get long GLD shares and short an equal dollar amount of SLV shares; this will provide you with the most direct way to take advantage of this relationship but I understand shorting isn't for everyone. You could also get long gold futures and short silver futures but again, futures aren't for everyone. However, there is another way that you could proxy this relationship and that is through GLD and SLV options. This is the least direct and most complicated (and possibly expensive) way to make a play on this relationship as many things factor into an option's price other than the underlying security's price. Out of the three methods, I like getting long GLD shares and shorting SLV shares in equal dollar amounts. This will provide you with the lowest cost, most direct way to take advantage of GLD's outperformance over SLV, should it materialize.

Pairs trades aren't for everyone and there are more profitable ways to take advantage of gold prices moving up if you think that is what will happen. However, I like this pairs trade because gold and silver tend to move in the same direction and this strategy allows you to mitigate your risk by seeking to capture only the difference between the moves. Thus, your upside is limited versus simply getting long gold but your downside is mitigated as well. This strategy is a low risk way to take advantage of historical patterns in the price action of these two metals.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may initiate a pairs trade at any time.