The Right Way To Trade The Gold Miners

| About: SPDR Gold (GLD)

Summary

Gold mining stocks have extreme volatility, making them difficult to trade.

Gold itself has highly inconsistent correlations with the dollar, inflation, and fear.

The best way to trade the gold complex is by studying the patterns between gold and the gold miners.

A simple long/short strategy using the price relationship as a signal is up 322% over 10 years.

This price relationship indicator is triggering a buy signal in GDX.

The gold trade has historically been very frustrating for me. Gold went into a multi-year bear market starting in late 2011, while currency devaluations across the globe were hitting their zenith. I long ago gave up trying to use fundamental and macro rationale as a trigger to buy or sell gold or gold miners. There's a far easier way to do so, by studying the close relationship between the two. For the purposes of the examples used, we will use the SPDR Gold Trust ETF (GLD) to represent the gold commodity, and the Market Vectors Gold Miners ETF (GDX) to represent the miners.

I've been an investor and trader for myself and clients for 20 years. Over those years I've come to trust one factor more than any other in deciding buy and sell signals. "What is the price action doing, when I compare it to what it should be doing?"

Simply put, I want to buy something when its price is no longer going down, even when fundamentals say it should be going down. And convexly, I want to sell something whose price is not going up, when fundamentals tell me it should be going up.

IT'S ALL RELATIVE

Years ago I developed an indicator which has served me well, which mathematically identifies the basic premise I just explained. I call it the "Global RSI." Essentially I'm comparing two parts that make up a whole, and tracking their price relationship. In the gold complex, I'm tracking the historical relationship between GLD and the GDX, and making trading decisions based on changes in that relationship.

The indicator first calculates what is essentially Beta... the average daily change in GDX when compared to GLD. Roughly, GDX has a Beta of 3 when compared to GLD. Whatever this number is, the indicator uses it as a baseline of 0. Changes in the baseline then give me buy or sell signals, as the price relationship starts to deviate from the baseline. In order for the trade to work, one premise needs to come to fruition - that in bull markets, the miners, due to financial leverage, should outperform the underlying commodity. In bear markets, the reverse should be true.

THE GLOBAL RSI IN ACTION

Below, I've charted GDX (green) against GLD (orange) and in the bottom half of the chart, we see the Global RSI indicator (red).

Source: TradeStation GDX and GLD 7/31/15 - 10/18/16GDX and GLD 7/31/2015 - 10/18/16 Sourse: TradeStation Click to enlarge

Source: Author created using TradeStation

It's a pretty straightforward analysis. As the Global RSI indicator starts to rise, it's telling me that the price action is improving from the normal baseline relationship. THIS WOULD TELL ME TO BE A BUYER OF GDX. You can see a faint blue line lagging the Global RSI indicator. I use that as a crossover signal as to when the GLOBAL RSI is expanding and contracting. If the Global RSI starts to fall, the relationship is turning bearish, AND I WOULD SELL (or sell short) GDX. Let's zoom in and see the near term price action up close.

Source: TradeStation GDX and GLD 3/15/16 - 10/18/16GDX and GLD 03/13/16-10/18/16 Source: TradeStation Click to enlarge

Source: Author created using TradeStation

On 10/13/16 we see a clear upward break out in the Global RSI indicator. A safer (and more accurate) way to use the indicator is to buy GDX and sell short GLD. (As a disclaimer, I took a long position in GDX at the close on 10/13/16).

KEEP IT SIMPLE!

Arguably, one of the most simple indicators in trading is the moving average. However, GDX is far to volatile to use moving averages. While you certainly can hit grand slams with it, you'll face a mind-numbing number of disastrous whipsaws.

Our indicator is essentially a "moving average of the GDX/GLD relationship." Since the relationship is far more consistent than the price, we can use a moving average with a manageable number of whipsaws.

BACKTESTING THE TECHNIQUE

The algorithm is very simple. Other than the math required to calculate the baseline relationship, the trading signals require only 2 lines of code in TradeStation.

*Buy GDX when the Global RSI crosses its trigger line (and perhaps sell short GLD as a hedge).

*Sell short GDX when the Global RSI crosses below its trigger line (and perhaps buy GLD as a hedge).

The Global RSI is charted above using the most recent 7 days of data as compared to the entire baseline history. The trigger line is simply the Global RSI level 2 days prior to the current day. I could add a few lines of code that would improve the results dramatically by reducing whipsaws, but I want to show the power of this very simple technique on its own, with no other variables.

10/18/06-10/18/16: Long and short GDX trading signals

Click to enlarge

Source: TradeStation Strategy Performance

Buy and Hold GDX (10 years): -34.23%

Total return of GDX with Global RSI: 322.67%

  • $10,000 each trade
  • $4 commissions each trade
  • 14.72% annualized

Below are some of the trading details from TradeStation's backtesting software:

Click to enlarge

Source: TradeStation Performance Reports

Note, even in long-term bear market in GDX, more money was made in long trades than short trades. In full and fair disclosure, I would not short sell anything as volatile and unpredictable as GDX without having some sort of protection in place.

CONCLUSION:

Trying to predict the price action of gold is extremely difficult, as it often deviates radically from what "conventional wisdom" tells us.

With Global RSI, we don't have to worry about what gold is doing, or why its doing it. Using the historic price action relationship between gold and gold mining stocks can tell us when the gold complex is ripe for a long entry, or a short one. With 2 lines of code only, you can see that the gold complex can be successfully traded without a care in the world as to why gold is moving the way it is.

The indicator has triggered a long position in GDX on 10/13/16. The strength of the signal suggests that there is low probability that this move is a head-fake. Adding strength to my signal is the apparent successful hold of support at the 200-day moving average ($23.25 ish).

I would add to GDX on any weakness, with a stop loss at 4% below the 200-day average, which is $22.56 as of 10/19.

Disclosure: I am/we are long GDX.

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.