This article here on Seeking Alpha piqued our interest. The gold-silver ratio chart has led the author to suggest a long-gold / short-silver trade. We have pilfered this author's chart, added the purple annotations and inserted it below.
For the purpose of this article we shall follow the referenced article and use the SPDR Gold Trust ETF (GLD) as a proxy for the gold price and the iShares Silver Trust ETF (SLV) as a proxy for the silver price.
The referenced article sets out the argument that the GLD / SLV ratio was about to bounce off the upper line of the channel outlined in black below offering the described pair trade. According to the author of this article, this pair trade eliminates some of the volatility inherent in the spot price of the two metals. To quote:
[...] 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.
Consider the thick purple rising trend line drawn into the chart above by your humble scribe. This purple trend line, in our opinion, is a representation of the simple fact that silver typically underperforms gold in times of falling prices. On the other hand, silver seems to outperform gold in times of rising prices. The ongoing correction, or as some would have it bear market, in both metals started in early fall 2011. We have marked this date in the chart above, and have also indicated the all-time highs of GLD and SLV that preceded this correction.
The author of the referenced article states in the comments section of his article:
[...] the relationship has shown a propensity to rhyme over time so based on that, I think gold will outperform.
We respectfully disagree with the generality of this statement and ask our readers to consider the two charts below. The right chart titled "Bear" shows the performance of GLD and SLV since the high in GLD, a period of 544 days to be precise. And the left chart titled "Bull" shows the performance for the same period of time preceding the GLD high.
- GLD and SLV generally trade in tandem.
- If prices go up - SLV outperforms GLD.
- If prices go down - GLD outperforms SLV.
We acknowledge that this dead horse has been flogged around the block a few times. However, these charts show that the suggested pair trade has only worked in a down-trend for the two metals past years. The suggested pair trade is therefore a bet on a continuation of this downtrend.
And if we decide to place a bet on the down-trend, why spoil the party with a long GLD position?
As far as volatility is concerned, we fail to see the advantage of the pair trade. All shown charts give plenty of evidence that the GLD / SLV ratio can produce highly volatile trading patterns. Simply consider the time around the silver high marked in the first chart for proof.
Or consider the time before the 2011 silver bull run indicated by a thin rising purple trend line in the top chart. The pair trade would have looked good for some time back then as well, only to go pear shaped big time and fast with the onset of the 2011 silver bull run.
Simply put we would like to suggest: if volatility is to be avoided, then precious metals are probably not the play of choice for the moment. And if trading precious metals in the current market then keep it simple and make sure to have your stops in place.
Additional disclosure: I own physical metals, but avoid paper gold and silver.