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Gold - Silver Ratio Investors’ Perspective

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Gold - Silver Ratio Investors’ Perspective Gold - Silver Ratio Investors’ Perspective Gold and Silver Prices Jan 2000 - Aug 2011 50 y = 3.2481e0.0016x Here’s a fresh, 45 R² = 0.92 in depth look at the 40 important gold-silver ratio indicator with tell-all charts 35 y = 0.0209x - 2.0747 and ideas to help you inter- 30 R² = 0.8949 pret the ratio and trade the pair. Keep in mind that the 25 y = 13.138ln(x) - 71.585 By: Przemyslaw Radomski - Chief Investment - Chief Radomski Investment By: Przemyslaw Autor Stall - Contibuting Mike and Strategist Profits Sunshine Investments Silver & Effective Gold for Tools majority of investors lose, R² = 0.7914 and that successfully playing Silver ($/oz) 20 the game in the markets is about doing 15 things that the majority does not. In order to outsmart the majority, we need to look 10 at the gold silver ratio in a unique way. 5 The gold-silver ratio is one of the first indi- 0 200 400 600 800 1000 1200 1400 1600 1800 cators traders look at to comprehend the state of the precious metals market. In- Gold ($/oz) deed, it has been out of favor among mod- Chart 1: Gold and Silver Prices ern investors who believe that a simple sinusoidal (smooth repetitive oscillation) instead of standard gold/silver and time started in 2000) is best represented by a movement does not often work. axis does not give you a clear idea about linear trend line, so the trend line is rising the ratio extremities, but it shows a clear and the slope is constant. If this trend line We believe that the gold silver ratio is view of general tendencies. Looking at a is to be taken into account, silver is even not outdated; it’s only how we view it that thing from different perspectives usually currently overvalued to gold and there- needs to be refreshed. The gold-to-silver leads to better decisions, especially in- fore, it might make sense to add to your ratio is the price of gold divided by the vestment-related ones. Let’s look at broad gold positions by selling silver (if you are price of silver, in other words, a single tendencies, inclined to trade this ratio) or making addi- ounce of gold is worth so many ounces tional purchases of metals by buying gold of silver. (The naturally-occurring ratio of We have drawn three trend lines to see instead of silver. The recent points are still gold to silver in the earth — 17:1) Some general tendencies for the scatter plot. A well above the linear trend line despite a traders look at the gold-silver ratio as solid exponential fit, a dotted linear fit and sharp correction in silver prices and a rally a way to determine if one commodity is a dashed logarithmic fit. All trend lines on in gold. The idea is to figure out whether over or undervalued relative to the other. the above chart are rising. That means silver is above the general linear fit or be- They then may try to short the overvalued that if we took the first stage of the bull low and accordingly make a call on which commodity and buy the undervalued com- market, the second stage or even the metal is overvalued. modity, with the hope of profiting from the whole bull market, we would see that on reversion to the mean. Comparing gold average, price of silver increases along This trend line may change its shape in prices to those of silver gives us a feel with the price of gold. the future as it will be calculated using for the price fluctuations between the two more price data. The cycle usually goes metals. Not much news, up to this point. What is like this – gold makes the first big move interesting to note is that in all these and silver catches up. Then gold moves A different perspective of looking time frames this correlation is best again and silver catches up again. Silver, at Gold-Silver correlation described using different trend lines. just like junior mining companies, tends Let’s start with a tell-all chart which lets What is not obvious is that all these trend to ‘take its time’ before finally starting to you see the whole structure of the corre- lines have different shape. First, we will move significantly. However, when it final- lation without using the time axis. Please focus on the long-term trend line and what ly does move, then it’s ‘up, up and away.’ take a minute to understand the chart and implications it has on the current situation We saw this in the recent silver rally or in the shape of the trend lines. on the metals market (with available data the first few months of 2004, 2006, 2008 as of August, 2011). and 2011. We have seen this type of per- Each point on the graph represents the formance on very long-term charts that go combination of the price of silver and gold Data for the whole bull market in precious back to the previous secular bull market at a particular date. Looking at this chart metals (in this case we’ll assume that it in precious metals. Silver’s catch up ma- 1 ments weakens, (one instrument moves terialized mostly in the final stage of the the illustration below favors realignment in up while the other moves down) the pair bull market. most cases. Also, in our subsequent es- trade would involve shorting the out- performing asset and to going long the says, we will establish why both gold and Another factor we notice from our graph is underperforming one. This is a bet on silver are expected to grow with one out- that in the first stage of this bull market, the spread between the two instruments performing the other and make the case the points follow the logarithmic trend- that are eventually expected to converge. for portfolio realignment rather than pair line better than the other two (linear Realignment would involve redirecting trade. and exponential). What does that mean? partial investments from the underper- In an initial phase of a bull market, silver former towards the outperformer, while One of the pillars of making trades based still staying long on both. This is a play lags in response to gold fluctuations.Then on a ratio (such as gold-silver) is the phi- on the relative price swing; as the under- comes a phase where the relationship performer picks up relative to the outper- losophy of mean reversion. Mean rever- is closer to a linear trendline. Finally, former, profits can be made irrespective of sion is more of a certainty in the case of we have an exponential fit where silver individual leg fluctuations. pairs because opposing forces of two cor- catches up in a big way (second stage related instruments tend to force the ratio of the bull market). One of the main prin- Divergence between a pair can be due to to revert to its historical average values. ciples of technical analysis is that history temporary demand/supply changes, bulky Imagine two strong magnets. Move the repeats itself, or at the very least, rhymes. buy/sell orders for one leg of the pair, two magnets apart, and there is a strong So we might infer that the catch-up stage significant news about one of the instru- tendency of the two to drift back together of this bull market is probably over (as ments, and so on. The underlying prin- once the external force weakens. Some- of mid-2011) and we may revert back ciple of mean reversion is that since the times the external force is strong enough to the gold-leads-the-way stage again instruments are fundamentally linked, the to drift them sufficiently apart to a degree where gold rises and silver lags. This normal relationship will resume once any that the magnetic field is no longer effec- is something we have been seeing indeed temporary effect is subdued. tive, or the strength altered. We will ana- in the last few points of the graph (most lyze methods to detect regime changes recent data of Aug, 2011). Certainly, the Any ratio correction can happen in three further on in our analysis. exponential trend line is no longer the best ways. Both legs move up and one out- fit. Whether we have moved towards an- performs the other, or both move down Pair Trading vs. Portfolio Re-align- other logarithmic trend line remains to be (where realigning works better). Only in ment - Example seen (when more points come across. Is the event that both legs move in different Expectation indicates predicted move- the bull market nearing an end? Not likely, directions does a pair trade work better. ment on which bet is taken. based on fundamental factors, so we may But, risks are higher in case of an unfa- see silver outperform gold again – just like vorable outcome. We will observe how it did in the first half of 2011. How to Play the Gold-Silver Ratio So far, we have discussed typical gold- silver ratio fluctuations to open up invest- ment opportunities based on the phase of the precious metals market. To make investments/trades irrespective of market conditions, we have pair trading. By taking up two legs (one long and the other short), a pair enables the investor to limit losses and gain from a number of scenarios in comparison to a standalone position that can gain only in case of only one favorable fluctuation.
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