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Why the Gold Silver Ratio is Worth Watching

July 19, 2016 by Lior Alkalay 1 Comment

There are many ratios in the trading world that are worth watching. But when it comes to trading precious metals there is one key ratio that everyone must know and should watch. That, of course, is the Gold Silver ratio which is essentially the price of Gold divided by the price of silver. You might be asking yourself what insights one could possible glean with such a ratio? The answer is potentially very valuable insights.

What the Gold Silver Ratio Means

On the surface, Gold and Silver should be identical, from a fundamental standpoint. They are both precious metals which investors buy as a hedge against fear. But, of course, that explanation just barely scratches the surface. When we dive a bit deeper into the fundamental nature of Gold demand vs Silver the difference becomes more apparent.

Gold, as its reputation suggests, is a safe haven tool primarily driven by investments. Investments in Gold are often driven by fear and risk aversion (which are two sides the same coin). Thus, we can attribute most of Gold’s price fluctuations to those sentiments.

Silver demand, on the other hand, is  driven both by safe haven demand by investments but also  by Industrial usage.

That difference creates a very interesting dynamic. When investors’ fears mount, demand for Gold tends to be stronger and the ratio tends to rise. When fears fade then investors believe industrial output will rise. That, of course, tends to benefit Silver and thus the ratio falls.

The Gold Silver Ratio as an Indicator

Examining the Gold Silver ratio chart below, a trader is able to take the pulse of fear levels. If the ratio is rising it may signal an escalation in investors’ fears. Consequently, that could signal that Gold demand is turning stronger. If the ratio is falling, fear is dissipating and Gold is turning weaker.

How is this useful in practice?

If you’re holding a long Gold position and the ratio is falling, you’re essentially riding a dying horse and Silver would be the better place to be. On the other hand, if the ratio is on the rise and you’re buying Gold, that’s positive reassurance to own Gold over Silver.

Of course, for Silver, the effects of the ratio would be the exact opposite. A rising ratio is an indication of weaker Silver demand compared to Gold.

It Gets Complicated

But besides gauging which precious metal is strengthening at the expense of the other, there’s one other dimension. Once again, the Gold Silver ratio chart sheds some light on this useful ratio.

The Gold Silver ratio has cycles. It has historical highs, where it tends to top out and fall, and it has historical lows. If the ratio is near its highs, then it might be a good idea to move into trading Silver. If the ratio is near its historical lows, it might be time to switch from trading Silver to trading Gold.

Gold silver ratio

Trading the Gold Silver Ratio

This might come as a surprise but the Gold Silver ratio is not just an indicator it’s also tradable. Even better, it’s actually rather easy to trade. Often, the ratio has simple and very distinct patterns that can follow a simple trend line. If you believe the ratio will trend higher, then you can buy Gold and short Silver with identical lot sizes. That way you will gain as the ratio rises.

For shorting the index one should do the opposite; short Gold and buy Silver with the same lot sizes.

For example, take a look at Point A from October of 2015. The ratio gained more than 10%, rising from 71, to where the trend line is above 80; that’s more than a 10% gain. Compare that to trading the EUR/USD; a 10% gain in the pair would roughly equal 1,000 pips.

Naturally, this simplicity doesn’t come cheap. First, you have to rely primarily on trend lines for short to mid-term trends (and you know what I think about relying too heavily on trend lines).  Of course, you can use the historical lows and highs to figure out what’s coming next but that means opportunities might be fewer. Second, this is margin heavy, since you essentially need to hold twice the margin, aka two positions in opposite directions.

Put another way, trading the Gold Silver ratio can be simple when it’s going right, but consider this could easily go wrong.

Gold Silver ratio

How to get started

If you plan to actually trade the Gold Silver ratio, first get used to using it as an indicator. Then, once you have a better sense of the way it behaves, you can use your own discretion as to whether or not it’s worth trading. If you’re thinking about using the ratio solely as an indicator, let me throw this out there: Don’t entirely rule out trading it. Occasionally, when the ratio is at a multi-year low or high, there can be a very nice opportunity arising that you might not want to miss. But the fact is, either way, as an indicator or as a tradable asset, the Gold Silver ratio is always worth watching

Filed Under: Trading strategy ideas Tagged With: gold, pairs trading gold silver, ratio, silver

Pairs Trading Case Study: Gold / Silver

May 20, 2013 by Rupert Hadlow 3 Comments

Finding a pair of currencies or commodities that can stand up to the cointegration test on both a short term and long term basis can be quite difficult. It is common for pairings to have some degree of distance or long term deviation away from the linear regression and this can greatly affect performance.

Several high profile market neutral hedge funds have been victim to this regression breakout. Long Term Capital Management (LTCM) is the most famous example. The fund lost several billion dollars in 1998 during the Russian financial crisis. Nearly every position in its bonds and derivative pairings went off the rails all at the same time.

Trading pairs is not full proof and strict risk management and cointegration retraining must be implemented. As discussed in our previous posts on correlation and cointegration, we are looking for the degree to which two variables will return to their common mean. This will determine our entry and exit strategy, and where we will place our stops.

In one of our previous articles – ‘Analysing Pairs with Correlation and Cointegration’, we identified Gold and Silver as a good potential trading pair due to its statistically high long term percentage levels. We calculated the cointegration using a free tool from the website – Catalyst Corner www.catalystcorner.com.

Download the tools for MetaTrader 4.

30 Day Correlation: 94.98%
2 Year Correlation: 26.99%
13 Year Correlation: 95.3%
2 Year Cointegration: 85%

Pairs trading with silver and gold

Silver (Black) Gold (Orange Green) 30 Minute Chart

Setting up Charts

Setting up a pairs template in MetaTrader is relatively simple and requires two free indicators (these have been included with the tutorial). The first indicator is that of the FX Correlator and the second is the overlay chart. Highlighted below are the step by step instructions on adding each to your chart.

1. Open Metatrader and Choose Chart
2. Drag the Overlay Chart onto the open chart window, and specify default settings. Click OK.
3. Attach the FX Correlator to the chart, click INPUTS and change all currencies to FALSE except for USD and AUD. The reason why we are keeping these two as TRUE is outlined in the trade setup section. Click OK.

Trade Setup

You will now see two indicators positioned on the chart window. The top overlay chart will highlight the price of silver in comparison to gold. You will notice that the general trend direction is quite similar (correlation), however there are points along the timeline where the prices widen and then regress (cointegration). These are the points that we are looking to profit from.

The FX correlator is a unique indicator that calculates a spread between the main chart window and specified other crosses. When we added the indicator to the chart, we only specified the AUD and USD currencies. Hence we can only see two coloured linear regression points along the time line. The reason we chose the Aussie dollar, was because of its susceptibility to commodity prices movements and the US dollar is the natural base cross with Gold and Silver.

Trading Opportunities:

• Long Gold and Short Silver when the USD crosses above the AUD on the FX Correlator.
• Short Gold and Long Silver when the USD crosses below the AUD on the FX Correlator.

In the diagram above, we have circled a number of trade setups. On the 14th of May at 4:00, the USD crossed higher than the AUD, triggering a potential Short Silver/Long Gold scenario. According to the chart, Silver regressed back to the mean and overlapped Gold at 12:00. The second possible trade scenario occured on the 15th of May at 20:00. As the AUD crossed above the USD, a Long Silver / Short Gold trade was triggered with the spread widening.

Risk Management

• Tight Stops on both crosses
• Calculate the correlation and cointegration of Gold and Silver regularly (daily basis). If the cointegration breaks down (below 80%) do not trade.
• Position size should be based on underlying value and may not be equal.

Filed Under: How does the forex market work?, Trading strategy ideas Tagged With: cointegration, fx correlator, overlay chart, pairs trading gold silver

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