The Gold/Silver Spread: Fool’s Gold Or a Golden Opportunity?

Gold/Silver Spread

Gold and silver are precious metals. The price movement between the two is highly correlated and silver has always been substantially cheaper than gold. Because of this, silver is often referred to as “poor man’s gold”.

Gold Silver overlay monthly

Gold Silver overlay monthly

Silver is typically more volatile than gold. Since silver and gold usually go in the same direction and silver typically moves at a faster pace, it stands to reason that the ratio between gold and silver will climb during a bear market and decline during a bull market.

The fundamental relationship, the strong correlation, and the volatility differences are all ingredients for spread trading opportunities.

The Ratio

Last week the ratio between gold and silver 70:1, which is the highest level it has seen since the spring of 2010. Based on what has occurred at this level before, we expect that things could get pretty exciting in the precious metals from here.

Gold Silver ratio 2002 weekly

Gold Silver ratio 2002 weekly

The last two times that the gold/silver ratio climbed to a multi-year high of 70:1 was August of 2002 and again in September of 2008. Both times, the ratio accelerated higher. The ratio surged to 80:1 by early 2003 and it rocketed to 84:1 in the fourth quarter of 2008.

Gold Silver ratio 2010 weekly

Gold Silver ratio 2009 weekly

Longer-term, these accelerations were the tail end of a move that preceded a major reversal. From the 2003 high of 80:1 the ratio plunged to a multi-year low of just under 52:1 in just over ten months. From the 2008 high of 84:1 the ratio plunged to a multi-year low of just under 59:1 in eleven months.

Either we should now be at the top of the gold/silver ratio and the bottom of the multi-month decline in precious metals…or else we are at the point where there is a blow-off acceleration in the ratio while gold and silver plunge to new multi-year lows.

The spread

On Thursday the February gold contract closed at $1,222.60. This puts the value of a 100/oz. futures contract at $122,260.00. The March silver contract closed at $17.48. This puts the value of a 5,000/oz. futures contract at $87,400.00. Therefore, the February gold contract closed at a premium of +$34,860.00 over the March silver contract.

Gold Silver spread 2009 weekly

Gold Silver spread 2009 weekly

On the weekly timeframe, the gold/silver spread peaked at an all-time high of +$34,525.00 in late December of 2008. After backing off $19k over the next several months, the spread eked out a slight new all-time high of +$35,125.00 at the end of May 2009. From there it backed off and established a double top at the 2008/2009 highs. The spread ultimately inverted and plunged to -$87,280 (premium silver) by the spring of 2011. That’s a decline of roughly $122,000 on a single contract spread!

Although the gold/silver ratio is at a level that could see a significant move in either direction, the gold/silver spread is testing a double top that was made at an all-time high. This is stiff price resistance. A reversal from here could start a major decline.

Trend Change Signals

Currently, a 100/oz. February gold contract is equal in value to roughly 7,000/oz. of March silver. A regular-size silver futures contract is 5,000/oz. and a ‘mini’ silver futures contract is 1,000/oz. Therefore, a trader can create a more equalized gold/silver spread position by comparing the value of a single 100/oz. February gold contract against the sum of the value of one 5,000/oz. March silver futures contract and two of the 1,000/oz. March ‘mini’ silver futures contracts. On that basis, here are a couple of setups that one could use to identify a bearish trend change for the February-March gold/silver (x7,000/oz.) spread:

First, a two-day close below the rising 30-day Moving Average (currently around -$6,651) would be a bearish event. The spread has not closed below the 30-day MA in over two months. In late May the February-March gold/silver (x7,000/oz.) spread made a two-day close below the 30-day MA for the first time in two and a half months. This signal was timely as the spread dropped roughly $10k over the following weeks.  Maybe it will work again.

February Gold March Silver (7,000 oz.) spread daily

February Gold March Silver (7,000 oz.) spread daily

Secondly, the February-March gold/silver (x7,000/oz.) spread rocketed past the April 30th top and prior contract high of -$5,324 in mid-September. Now that this price resistance level has been clearly broken, it becomes price support. Therefore, a close back under the April 30th top would negate the breakout and signal a bearish trend change.

Trade Strategy:

For tracking purposes, the blog will make a hypothetical trade by selling one 100 oz. February gold contract and simultaneously buying one 5,000 oz. March silver contract and two 1,000/oz. March ‘mini’ silver futures contracts if the spread closes below the rising 30-day MA. Initially, the spread will be liquidated on a two-consecutive day close $500 above the contract high that precedes the entry signal.

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