Gold/Silver Ratio Continues To Show Strong Signal

| About: iShares Silver (SLV)
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Over the past nine months or so, I have written three articles highlighting the trend of gold (NYSEARCA:GLD) outperforming silver (NYSEARCA:SLV) via the popular ETFs. In each, I've suggested that gold is set to continue to outperform silver and in each case, investors following this strategy have been left with nice risk-adjusted gains. The most recent of these articles in early December showed a strong rebound off of support in the GLD/SLV ratio as seen in the chart below. The long-term trend is intact, as we can see below, but in this article we'll take a look at a shorter-term chart to see what the short-term trend looks like within the context of the longer-term trends we see here.

This is the same chart as above but zoomed in to show only January 2011 to the present as opposed to the past seven years.

We already know the long-term support is still working from the first chart and if we take a look at this shorter-term chart, we see a very clear, tradable channel. In fact, over the past few months we've seen the ratio hug the bottom of the channel very clearly following the sharp outperformance of silver over gold around the time tapering was put on the table by the Fed. This is the kind of trend you should look to take advantage of when trading precious metals. Since they aren't companies with earnings, pay no dividends and in the case of gold, have little industrial use in the context of the size of the market, it can be difficult to value them. However, if we notice trends like this one we can have the upper hand in trading these instruments. Some people don't believe in the validity of the gold/silver ratio but this chart right here lends credence to it by itself.

I believe the setup we've just seen offers the best chance to maximize risk adjusted returns in the precious metals. We've not only got a clear long-term support line, as seen in the first chart, but we've also got a shorter-term channel, as seen in the second chart, that provides a very clear "line in the sand" from which to trade. If the ratio falls or rises out of the channel, we'll know the trend has changed in the short term. If that happens, a reassessment of not only the shorter-term trend but also the larger, longer-term trend would be appropriate. However, since I began writing these articles, that hasn't happened and traders who have been long gold and short silver have done quite well.

So why not just go long gold and/or silver? The idea behind this trading strategy is to mitigate risk. Gold and silver obviously trade somewhat in lockstep in terms of direction but the magnitude of moves is often different, as evidenced by my charts. The idea behind this strategy is to eliminate the risk of simply holding these metals and take advantage of the difference in the magnitudes of the moves.

This chart depicts GLD alone over about the same time period as my second chart and the results are striking.

Does this look like something you want to own? Me neither, and the point of this strategy is to eliminate this type of volatility and simply take advantage of gold's outperformance over silver. Compare my second chart to this one and you'll see why I like this strategy so much; you aren't subject to the whims of gold traders selling down gold violently every time someone from the Fed speaks and while your gains could theoretically be greater just holding gold, you can see from the chart above you can get crushed doing that too. If you still don't believe in the power of the gold/silver ratio trade, just examine my second chart and this one and you'll see why I find this to be a much better alternative to just buying and holding one or both metals.

This strategy is for people who are comfortable shorting silver either via the ETF or some other method; I chose the ETF because it is most accessible to retail investors. And keep in mind, silver may begin to outperform gold at some point as it has happened before. However, after looking at my charts I still think that gold is going to continue its outperformance and traders can still take advantage of the move. If we see the ratio break down through the bottom of the channel I highlighted and/or through the long-term support on the first chart, we'll need to reassess at that time to see if it is time to go long silver and short gold. But for now, the trade continues to work and it isn't too late to capture some further gains.

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. I am long GLD and short SLV, as highlighted in the article