Gold/Silver Spread: Get Ready To Reenter!

Gold/Silver Spread

Last week the blog exited a hypothetical short position in the gold/silver (x7,000/oz.) spread for a modest profit of approximately +$2,100 ( not including commissions). The reason for the exit was because the spread made a downside break of the multi-month trading range and then turned right back around. This failed breakout is something we like to call a ‘Wash & Rinse’ buy signal as it usually leads to a sizable move in the opposite direction of the failed breakout. It appears that covering the short position was a good move.

December Gold Silver (7,000 oz.) spread daily

December Gold Silver (7,000 oz.) spread daily

For the last several months, whenever the December gold/silver (x7,000/oz.) spread has reversed off the bottom of the trading range it has gone back up to somewhere between +$7k and +$8k. Therefore, the IMC blog is going to reenter the short position on a rally back up into this area. There are two reasons for this. First of all, the probabilities of selling into a rally this high are favorable since the spread has been able to reach this level many times in the last six months. Secondly, by selling into a rally instead of waiting for a breakout, we can use a much tighter exit point. This creates a more manageable risk level and, therefore, a much better reward-to-risk setup.

Remember the Macro

After being held hostage in a trading range for the last half a year, it’s easy to forget the big picture of where the gold/silver spread is. This is because a trader can get fixated on the daily and hourly timeframes as the spread frustrates us with false breakouts or lulls us to sleep from the sheer boredom of it all. This is why it is important to not just sit in front of the trading screens all day. You need to have other markets to watch, research to do, a dog to walk, etc.

To regain perspective and remember why the gold/silver (x7,000/oz.) spread is even a short sale candidate in the first place, take a look at the longer-term timeframes. In particular, let’s look at the ratio between gold and silver.

Gold Silver ratio weekly

Gold Silver ratio weekly

After reaching a six-year high of nearly 76:1 in late November, the gold/silver ratio has been in a tight trading range for months as it peaks either side of 75:1 and bottoms either side of 70:1.

The last two times that the gold/silver ratio exceeded 75:1 it eventually peaked out at 80:1 in early 2003 and peaked out at 84:1 in the fourth quarter of 2008.

The ratio reversed and declined to a multi-year low of just under 52:1 in the ten months after the 2003 top. A sharp one-month bounce followed. The downtrend then resumed as the ratio declined for another two and a half years to a multi-year low of just under 46:1.

After the 2008 top was established, the ratio declined for about a year and temporarily bottomed near 59:1. A three and a half month rally followed. The ratio then topped just below 71:1 and proceeded to go into a death spiral as it dropped relentlessly for nearly fifteen months. It reached the final low in late April of 2011 when it closed at a twenty-eight year low of 32:1.

The point of this is that, although the gold/silver ratio has been in a ‘boring’ trading range since it peaked in November, it is historically very expensive and has a strong precedent of initiating major bearish reversals from these levels. Therefore, it is still a worthy short sale candidate. Spread traders should stay the course.

Trade Strategy:

The blog will work a hypothetical order to sell one 100 oz. December gold contract and simultaneously buy one 5,000 oz. December silver contract and buy two 1,000/oz. December ‘mini’ silver futures contracts if the spread rallies to +$7k (premium gold). Initially, the spread will be liquidated on a two-consecutive day close above +$9k.

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