Use Silver's Volatility to Control Risk

Includes: AGQ, GPT
by: Hard Assets Investor

By Brad Zigler

Real-time Monetary Inflation (per annum): 4.2%*

You've always known that silver's a volatile commodity, right? After all, silver's jumped 34% this year. Gold, meantime, has climbed only 9%. As a result, the gold/silver multiple – the numerator in the gold/silver ratio – has dropped from 80 to 66. Put another way, an ounce of gold could buy 80 ounces of silver on New Year's Day. Today, it only buys 66 ounces.

Gold got cheap - or at least cheaper - in relation to silver. A lot of that has to do with the market's balance of fear and the prospects for economic recovery. That's something we've discussed before and no doubt will do more of in the future.

Gold/Silver Ratio

The important thing is that the ratio is tradable. Futures traders have known that for years. They've been able to make money from the ratio's vagaries by pitting opposite positions in gold futures against silver. When the ratio was expected to expand, they'd buy gold futures and sell silver futures. For a contracting ratio, the trade would be reversed.

Until recently, securities traders could only trade one side of the ratio. But, with the introduction of the ProShares lineup of leveraged commodity ETFs (exchange-traded funds), margin-shy investors now have the option of trading the ratio both ways.

This year, for example, equal-sized long positions in both the ProShares UltraShort Dow Jones-UBS Gold ETF (NYSE Arca: GLL) and the ProShares Ultra Dow-Jones UBS Silver ETF (NYSE Arca: AGQ) would have generated a 23% return. Considering the fact that the gold/silver ratio had shrunk by 18%, that's not bad.

It's all the more remarkable when you consider the volatility of the underlying metals. On its way to that 34% year-to-date gain, silver exhibited an annualized price volatility of 40%, nearly twice that of gold. The differential volatilities for the leveraged ProShares portfolios are equally dramatic. The ProShares portfolio cranks out a 71% annualized risk against the 46% rate chalked up by the gold fund. When the two funds are combined, though, the risk is comparatively tame. This year, the gold/silver package exhibited a volatility of 38%. That earns the deal a rather healthy 0.93 reward-to-risk ratio.

Shrinking The Gold/Sliver Ratio Through ETFs

If you think silver's continuing prospects are more bullish than gold's, you might want to consider the trading opportunities offered by the ProShares ETFs. Individually, the ETFs are very risky; combined however, the metals' volatility and the funds' leverage make for a pretty attractive gamble.

*Note: To provide a longer-term perspective, we've pushed back the base for our real-time monetary inflation indicator to May 2006. The base previously was January 2008. The indicator represents the average annual rate of monetary inflation over the period. The current 12-month inflation rate is -0.8%.