The New Way To Trade GLD

| About: SPDR Gold (GLD)

The Gold ETF (NYSEARCA:GLD) has followed the rise of gold since its inception in 2004. It is, according to ETF Database, the second largest ETF behind the S&P 500 ETF (NYSEARCA:SPY). Many investors saw this coming and profited greatly, but many came a bit late to the party and are wondering what the next move is.

The new way to trade:

When an ETF becomes this popular, or crowded, depending on your point of view, it becomes very difficult to have an informational edge on the masses about the direction a commodity will head. What becomes easier is relating it to other similar commodities. This is because of increased liquidity and analysis. In this case we will use silver via the silver ETF (NYSEARCA:SLV).

Here is the regression result from weekly prices of GLD and SLV over the last 5 years with prices measured every Monday. The two most important fields are highlighted.

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Here we can see that the price of silver has explained 83% of the price of gold over the last 5 years. Here we must define our trade thesis; it is that gold and silver will act more like substitutable commodities as they grow in popularity, and will therefore have a tendency to converge on a normal exchange ratio.

Click to enlarge

How to find opportunities:

Take the price of SLV, multiply it by 3.275, and then add 47. Or use this handy calculator I have created. If the price of GLD is substantially different, defined in the above graph and calculator as + / - 25%, then you buy GLD if the price is too low or sell short if the price is too high. When the difference gets back to within + / - 5%, the trade is closed.

Risks:

You do not have to worry about metals as a whole being in a bull or bear market because of you are net neutral (long one precious metal and short another), but you do have to recognize your leverage (if the gap widens by 10% you will see a loss of 20% due to your double exposure). You must also be mindful that a sudden shift in demand (most likely to come from microchip producers or similar technological advances) or shift in supply (either via large mine discovery or sudden shortage) could ruin the thesis and force you to close your positions.

However these shifts are unpredictable and are as likely to benefit your position as to hurt it, and as long as you are not over-leveraged this is a minor risk to bear.

Conclusions:

You can amplify the results by going long GLD and short SLV when GLD is too cheap, and vice versa when GLD is too expensive. This trade would have gone round trip 5 times in 5 years. The gap has never widened more than 12% after the trade is "on" (actually 11.36% on Monday closes). These five positions took 2, 22, 22, 26, and 50 weeks to be closed out for an average holding time of 24.6 weeks.

If you are like me and you aren't sure where the precious metals are headed, or simply think they have reached a plateau, you can still make money with this method of arbitrage. Like all arbitrage trades, there are risks that could cause a permanent shift in the relationship. A permanent demand or supply shock in either commodity is the major risk of this trade.

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.