Mean Reversion Underway
Last spring we said that the plunge in the copper(x2)/gold spread was setting up for the buying opportunity of a lifetime. We reiterated this statement again in the summer.
Looks like we were right.
The IMC blog bought a December copper(x2)/gold spread at -$23,100 (premium gold) on September 29th. Here we are two months later and the spread is trading at a nearly seventeen-month high of +$15,740 (premium copper)!
Currently, the spread appears to be on track for a price resistance zone between the 2015 high of +$28,190 (premium copper) and the November 2014 high of +$34,380 (premium copper). Based on history, a rally into this area after an inversion in the spread seems very likely. On the surface, this seems like it might be a good price zone to consider bagging the profits.
The ratio between copper and gold, however, argues that the spread will greatly exceed the price zone between the 2015 and November 2014 highs.
History shows that prior events where two copper contracts traded at or below the value of one gold contract were followed by reversals to where the two copper contracts would reach a minimum premium of 66% or more over the value of one gold contract.
Just to hit the minimum ratio of 1.66:1 from here, the copper(x2)/gold spread would have to soar to +$53,475 if the current copper price remained the same. And if the current gold price remained the same, the spread would have to reach -you better sit down for this one- a nosebleed level of +$78,540!
Split the difference and you’re looking at a projected target of +$66,000 for the ratio to reach 1.66:1.
Therefore, it makes sense to simple roll the December spread over right here ahead of the First Notice Day for the December contracts and stay on the ride.
Sell the two December copper contracts and simultaneously buy two March copper contracts at the market-on-close on Monday, November 28th. Also, buy back the one short December gold contract and simultaneously sell one February gold contract at the market-on-close on Monday, November 28th. This will roll the position from the December spread to the March-February spread.