How To Trade The Gold/Silver Spread

In my refrigerator, a jar of something called "sandwich spread" has been lurking for weeks. I honestly don't know how it got there, but I suspect one of my Canadian friends who's been invited over for our backyard barbecues may have brought his favorite along and then forgot to export it from our premises.

I would have preferred him leaving some of his Molson behind.

You see, that's the thing about this condiment, which is a combo of mayonnaise and pickled vegetables. You either love it or hate it. I know of no one who's ambivalent about it.

So it goes with another type of spread: that which pits one futures contract against another. Spreads can precisely provide the nuanced approach desired by some traders, while boring the hell out of others.

A lot of misconceptions abound about spreads, largely because they're unique to futures. There are no direct analogs in securities (we're talking stocks vs. futures here, not options).

Earlier this week, a Desktop column examined the gold/silver ratio ("Every Silver Lining Has A Cloud") and promised a follow-up on the probabilities of a breakout move by the ratio. Breakouts in the gold/silver ratio are a favorite of spread traders, so why not look at the trade through their eyes?

 

What Makes A Trade A Spread?

A spread consists of two or more related futures positions. Note the word "related" here. In order for a spread to be recognized for margin purposes-more on that in a moment-there has to be an economic connection between its constituents. Plainly, gold and silver are fellow-traveling precious metals, but formal recognition of the spread by the exchange clearinghouse is required to derive the spread's benefits.

What benefits? Well, in most cases, reduced margin requirements.

Let's look at how this facilitates a gold/silver ratio trade.

COMEX gold is traded in 100-ounce contracts, which require a minimum performance bond (or margin deposit) of $5,739 each. COMEX silver's $6,750 margin requirement is based upon a 5,000-ounce contract.

If you think the gold/silver ratio will move in the white metal's favor, then you might be inclined to buy silver. By purchasing silver outright, however, you're only going to make money if prices advance above your buy point. In contrast, selling gold against a silver purchase wagers on an improvement in silver's buying power, whether it derives from a rise in silver's price or a decline in gold's. A spread, therefore, gives you greater flexibility.

You won't be required to meet the outright margin requirements for each of the spread's legs, but you do have to meet the clearinghouse spread rules. Spread treatment for a gold/silver trade is based upon a 2-to-3 ratio. For every two gold contracts bought or sold, you must take an opposite position in three silver contracts.

Thus, the spread bet would be made by purchasing three silver futures while selling short two gold contracts. The clearinghouse grants a 50-percent margin credit for the spread, which would bring the minimum margin deposit to $15,864 for all five contracts:

 

[($6,750 x 3) + ($5,739 x 2)] x .50 = $15,864

 

Trading The Spread

Suppose we use the December contracts for our ratio trade. As of Sept. 1, gold futures settled at $1,248.10/oz and silver at $19.38/oz, yielding a ratio of 64.4-to-1. Banking upon an increase in silver's purchasing power means you're looking for the ratio to decline (in other words, the number of silver ounces bought by one gold ounce diminishes).

Suppose we set up our trade and watch as the gold/silver multiple declines to 60x. The ratio could decline as metal prices advance:

Gold/Silver Ratio Declines (Bullish Move)

	Long Dec. Silver (3)	Short Dec. Gold (2)	Ratio
01-Sep-10	$19.38	$1,248.10	64.4x
XX-XXX-10	$21.08	$1,265.00	60.0x
Net	+$25,500	-$3,380

 

This scenario would yield a $22,120, or 139 percent, return on margin.

The ratio could just as well decline as metals prices fall. A slip in gold's price to $1,100, for example, could be accompanied by silver's decline to $18.33:

 

Gold/Silver Ratio Declines (Bearish Move)

	Long Dec. Silver (3)	Short Dec. Gold (2)	Ratio
01-Sep-10	$19.38	$1,248.10	64.4x
XX-XXX-10	$18.33	$1,100.00	60.0x
Net	-$15,750	+$29,620

 

The $13,870 net profit that ensues would give you an 87 percent return on your performance bond.

Of course, there's no guarantee of a decline in the gold/silver ratio. A widening of the ratio could subject you to open-ended losses, whether prices advance or decline:

 

Gold/Silver Ratio Climbs (Bearish Move)

	Long Dec. Silver (3)	Short Dec. Gold (2)	Ratio
01-Sep-10	$19.38	$1,248.10	64.4x
XX-XXX-10	$17.00	$1,156.00	68.0x
Net	-$37,500	+$18,420

 

With this move, you'd lose $19,080, or 120 percent.

 

What Are The Odds?

We've seen the gold/silver ratio move into an increasingly tight range over the past year. This pattern is a typical setup for a breakout move. So the question spread traders now ponder is the probable direction of the breakout-to a higher or lower multiple?

 

Gold/Silver Ratio

 

We can apply a little probability theory here to better visualize the odds. Over the past year, the average for the ratio was 64.5-to-1. Volatility has been clocked at 21.4 percent, meaning there are two chances out of three that, in a year's time, the ratio will end up in a range plus or minus 21.4 percent from its average. That makes for a one standard deviation range bounded by a 50.7x multiple on the downside and by 78.3x up top.

So if volatility remains constant, the odds of a breakout through a standard deviation are, logically, small:

Volatility Remains Constant at 24.1 Percent

Ratio Moves:	30 days	60 days	90 days
Above 78.3x	0.2%	2.3%	6.5%
Below 50.4x	0.0%	0.5%	2.1%
Exceeds either	0.2%	2.8%	8.6%

 

However, the essence of a breakout is increased volatility. If there's a short-term spike, say to the 35 percent level, the odds look quite different:

 

 Volatility Spikes to 35 Percent

Ratio Moves:	30 days	60 days	90 days
Above 78.3x	4.0%	14.5%	24.5%
Below 50.4x	1.1%	7.1%	14.2%
Exceeds either	5.1%	21.6%	38.6%

 

As we've seen, though, we don't need to move the ratio needle very far to make a handsome profit on a gold/silver spread. We saw the gains and losses attained from a narrowing of the ratio to 60x as well as those garnered from a widening to 68x. What are the odds of either level being attained at a 21.4 percent volatility?

 

Volatility Remains Constant at 24.1 Percent

Ratio Moves:	30 days	60 days	90 days
Above 68x	36.0%	51.8%	60.1%
Below 60x	26.4%	42.6%	51.5%
Exceeds either	61.9%	88.1%	96.6%

 

Viewed from a volatility perspective, the odds favor a move upward in the gold/silver ratio, meaning gold's purchasing power is more likely to increase rather than wane. Traders heeding the odds would then buy gold futures against the short sale of silver contracts.

There's something else these probability tables tell us. A hike in the gold/silver ratio would indicate the metals' fear premium is strengthening-a likely consequence of continuing dismay over economic prospects. Downticks in the ratio would indicate more enthusiasm for silver and its industrial applications in an improving economy.

Forewarned is forearmed, I always say.

All this has made me hungry for a sandwich ... and a Molson.

Looks like the wedge broke Looks like the wedge broke to the down side. Good for silver. Submitted by Anonymous (not verified) on Sat, 2010/09/04 - 3:33pm » reply |