Gold/Silver Trade Still Intact?

Jul.23.14 | About: SPDR Gold (GLD)


The gold/silver ratio has provided traders with many opportunities to take advantage of gold's outperformance of silver.

Silver has outperformed in recent months, opening up an opportunity to put the trade on again.

We'll look at how to put the odds in your favor with this trade.

Over the past year or so, I've been pounding the table for buying gold (NYSEARCA:GLD) and shorting silver (NYSEARCA:SLV) in a pairs trade to take advantage of historical relationships. Taking the emotion out of trading gold and silver, which is quite the task for some investors, and using a ratio instead to understand how gold and silver interact with each other, we can put the odds in our favor when dabbling in the metals. That is the goal of trading on ratios, as we simply look at the chart and decide what to do.

Below is the chart of the GLD-to-SLV ratio since my first article on the subject in April of last year (courtesy of StockCharts). As you can see, the ratio has moved around quite a bit. At around six when I first profiled it, gold traded up sharply in relation to silver, and the ratio hit 6.7 before crashing back down to 5.6. However, a strong rebound has ensued, and once again hit 6.7 before coming back down to settle in the 6.2 to 6.3 area. These movements have provided traders with a lot of opportunity to make money over the past 15 months, and if we pay attention to the ratios, we can make some money going forward.

Click to enlarge

My recommendations since profiling this ratio have been to buy gold and short silver. In this trade, you'd profit from the ratio moving up, as it would mean that your long gold position is becoming more valuable through gains and your short silver position is becoming more valuable as its price declines. While this strategy is certainly volatile and risky, it can provide tremendous gains for those that want exposure to such a risk/reward scenario.

It is because of this volatility and risk that we must be disciplined in trading this ratio. The ratio has moved up very strongly after silver vastly outperformed gold late last summer, and the ratio plummeted almost a full point in a very short period of time. Those traders that had this trade on would have taken substantial losses, and that is something that cannot be understated; you are potentially taking on more risk in putting this trade on than simply buying gold or silver, due to shorting. In addition, if the trade moves against you, it moves against you in a big way. You must be comfortable with these risks and understand them fully before engaging in this trade.

Having said that, I'll reiterate why I like this strategy over simply picking gold or silver to buy. Gold, in particular, is a very emotional trading vehicle. It has no "real" value other than it is used as a currency. Thus, it becomes very difficult to ascertain what gold should be trading for. As we all know, gold is used as a fear hedge or inflation hedge, but that doesn't help you value it; it simply explains some movements in the price some of the time. Silver is similar, but does actually have some practical industrial uses. Still, it is also hard to value.

This is why I don't like to simply try and buy gold or silver; nobody knows what they're supposed to be worth or what they should be worth, and if anyone tells you they do, they're lying. That is where the pairs trade comes in; by putting on the pairs trade, we can take advantage of relative price movements rather than absolute price movements. With the ratio trade, I don't care if the prices of gold and silver move down 50% or more; I just care how one is performing relative to the other.

I still like this trade going forward, as we've seen a very tight consolidation in the 6.2 area for the past month or so. The long-term trend for this trade is still intact, as we are well below the highs of 6.7. That is the level at which you should target selling your position, as it has been pretty steadfast over the last 15 months. Remember, this is a trade and not an investment, and as such, is not a buy-and-hold kind of thing; the idea is to take advantage of gold outperforming silver until the ratio gets to 6.6 or 6.7, and then sell. When we see the ratio come back down, like it has in recent months, you can put the trade on again.

As long as the trend remains intact, there is no reason this trade shouldn't put the odds in your favor. If the ratio breaks down and silver begins outperforming gold such that the ratio breaks its uptrend convincingly, you may consider switching and getting long silver and short gold. However, we are a long way from that, and the long gold/short silver trade is still in play. Just remember to stay disciplined with buy and sell targets and take the emotion out of trading metals.

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

Additional disclosure: I may put on a long gold/short silver trade at any time.