Gold/Silver Spread: The Next Big Move?

A Personal Note

Readers may have noticed that posts on the IMC blog have been sparse as of late.  This has been due to time constraints as I’ve been juggling several projects, including a potential launch of an RIA.  (As you would probably guess, the firm will be considered an “active manager” of assets.)  

This may or may not impact how I’m allowed to continue blogging on the subject of spread trading in the futures markets.  Until then, I will try to make a few posts on some current opportunities.  Should anything change because of the RIA business, I will keep you updated.

Tip of the Iceberg

Last year, the gold/silver ratio clipped the double top that was established just above 80:1 in 2003 and 2008.  It then rolled over and triggered a Wash & Rinse sell signal.  Based on historical precedent, I provided an argument for why I expected this to be the start of a wicked decline that could ultimately send the ratio below 50:1.

Gold Silver ratio monthly

Gold Silver ratio monthly

This outlook for a decline in the gold/silver ratio was intrinsically a bullish outlook for precious metals.

The ratio bottomed a little below 66:1 last summer, went into a messy trading range for several months, and finally made a sizable bounce from late March into early May.  It never came close to the downside target I was and am expecting.

Here’s what recently caught my attention: the early May multi-month high of nearly 76:1 just happened to be right near the Fibonacci .618 retracement of the entire decline from the March 2016 twenty-one year high to the July 2016 multi-month low.  It also coincides with the bounce high from last May.

Gold Silver ratio daily

Gold Silver ratio daily

After tagging this resistance area three weeks ago, the gold/silver ratio has been backing down.

Based on the fact that the initial downside objective of 50:1 or lower has not been achieved and the fact that the ratio rolled over after hitting resistance, I can’t help but think this could be the start of another sizable down move…maybe even the one that finally takes it to 50:1.

Backed By the Buck

Remember, a drop in the gold/silver ratio usually means that precious metals are on the upswing.  This is because silver tends to move faster than gold.  When the ratio rises (like over the last few months), it is because silver is dropping faster than the gold.  Conversely, when the ratio drops, it is because silver is moving up at a faster rate than gold.

Many people know that there often tends to be an inverse relationship between precious metals and the US dollar.  Therefore, a decline in the greenback should be supportive of an increase in the price of precious metals and, by extension, a drop in the gold/silver ratio.

As it turns out, there is mounting evidence that the greenback is on the downswing.  This is supportive of the idea that the gold/silver ratio should be heading lower from here.  I will shortly be publishing a post on Martin Kronicle that lays out the reasons that the US dollar has peaked.  In broad strokes, though, it’s due to monetary policy, cycles/seasonal patterns, and recent price behavior.

US Dollar index daily

US Dollar index daily

Let me also state for the record that I am not a gold bug.  I am a gold bull when prices are moving higher and I am a gold bear when prices are moving lower.  My only intent is to be positioned on the right side of the trend in precious metals.  As famous speculator Jesse Livermore said, “There is only one side of the market and it is not the bull side or the bear side, but the right side.”

Trading the Spread

The December gold/silver ratio closed a little below 73:1 on Friday.  Currently, the closest that a trader can get to creating a ‘dollar neutral’ spread position in the futures market is to trade 100 ounces of gold against 7,000 ounces of silver.  This can be accomplished by shorting one 100 oz. gold futures contract, buying one 5,000 oz. silver futures contract, and buying two 1,000 oz. ‘mini’ silver futures contracts.

Not surprisingly, the price chart for the December gold (100 oz.)/silver (x7,000/oz.) spread looks very similar to the chart of the gold/silver ratio in that it recently hit an eleven-month high, clipped the major Fibonacci .618 resistance line, and then rolled over.  Technically, this appears to be a good reason to take a shot at the short side of the trade.

December Gold (100 oz) Silver (7,000 oz) spread daily

December Gold (100 oz) Silver (7,000 oz) spread daily

The midpoint of the current pullback is at +$6,520 (premium gold).  That’s nearly $2,500 from the current pullback low.  Since the prior bounce off the May 16th low was $2,141, getting a bounce to the current midpoint doesn’t seem all that difficult.  Therefore, a bounce to +$6k is not an unreasonable expectation.

The May multi-month high of +$8,982 is near-term resistance.  Shorting a bounce to +$6k and exiting on a two-day close above +$9k seems like a logical play.  If so, it would set an initial risk expectation of somewhere in the neighborhood of $3,000.

It is important to keep in mind, however, that this isn’t a guaranteed cap on the risk because we have no idea how far above +$9k the spread could close if it moves adversely.  But we can at least use it to give us some sort of rough estimation of the reward-to-risk profile on the trade.

If our thesis is correct, the spread should not have any problem returning to the 2016 low of -$9,315 (premium silver).  This is the minimum downside expectation.  Shorting at +$6k with an initial risk of approximately $3,000 on the trade puts the reward-to-risk ratio at 5-to-1 if the minimum downside expectation is met.

But a ratio of 50:1 (our minimum macro projection) implies that the gold (100 oz.)/silver (x7,000/oz.) spread would be priced somewhere between -$35,000 and -$51,000 (premium silver).  With that sort of price target, the initial risk of approximately $3,000 sets the reward-to-risk ratio on the trade somewhere between nearly 14-to-1 and 19-to-1.

On the one hand, the reward-to-risk may be a little overstated since we cannot ascertain the exact risk on the initial trade.  On the other hand, we didn’t do any projections on the impact that pyramiding would have if we add to the position if the trend unfolds in our favor.  That seems like a fair trade-off to me.

As a speculator, this kind of a potential payoff seems like a pretty smart bet.

Trade Strategy:

Place a hypothetical order to sell one December 100 oz. gold futures contract, buy one 5,000 oz. silver futures contract, and buy two 1,000 oz. silver futures contracts if the December gold (100 oz.)/silver (x7,000/oz.) spread closes at +$6,000 (premium gold) or higher.  Initially, liquidate the position on a two consecutive day close above +$9,000 (premium gold).   

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