While I'm not a gold bug per se, I can always get behind a winning trade - and long gold has been just that in recent months.

Since the end of November 2018, gold prices have increased roughly $100/ounce, or about 10%. With gold briefly moving above $1,340 in late February, we are now back in sight of the "nosebleed" prices observed at the start of this decade (about $1,800/ounce in 2011).

The most surprising aspect of the recent gold rally is that the momentum has sustained itself despite the fact that equity prices have also been rallying. After all, isn't gold usually perceived as a safety asset, which is bid up when most other asset classes are experiencing "de-risking?"

While that assertion may reflect popular market sentiment, it's not exactly correct.

tastytrade conducted an extensive study on gold's historical relationship with equity prices last year, and the results showed rather conclusively that this ongoing relationship is anything but conclusive.

As you can see in the graphic below, the correlation between gold and equity prices has varied between strongly positive and strongly negative (and even zero correlation) over the years included in the study (1990-2018):

Gold & Stocks

Given the above information, it's a lot easier to rationalize the current movement in gold prices vis-a-vis stock prices - historical data clearly shows that they have rallied in unison at times in the past.

So what other information can we examine to better understand the current dynamic in the precious metals sector?

One traditional metric that futures traders often utilize is the Gold Silver Ratio. Gold and silver enjoy a strong positive correlation, but over time the relationship tends to fluctuate between strong, and stronger. Traders often use this variable relationship as an opportunity to deploy a pairs trade involving the two.

In practical terms, the Gold/Silver Ratio simply reports the amount of silver it takes to buy one ounce of gold. As such, the ratio is calculated by dividing the current price of gold by the current price of silver.

Currently the Gold/Silver Ratio stands just short of 84, which is $gold/$silver ($1320.10/$15.78 = 83.65). That means it takes 84 ounces of silver to buy a single ounce of gold.

Over the last one hundred years, the Gold/Silver Ratio has ranged between about 15 and 100. That’s a fairly big difference in the respective piles of silver required to buy an ounce of gold.

However, in the last 20 years, that range has narrowed to more like 50 and 90. That means, at 84, the Gold/Silver Ratio is still very close to its recent historical highs (and not far from all-time highs, for that matter).

What this means in a practical sense is that gold has been rallying more strongly than silver in recent history. Traders that think the relationship will mean revert (i.e. that the Gold Silver Ratio will decline) typically consider selling gold and buying silver in these instances.

Logically, this makes sense, because a decreasing price of gold (the numerator) and an increasing price of silver (the denominator) would indeed result in a lower Gold/Silver ratio.

On the other hand, it’s entirely possible some traders are piling into gold because it is exhibiting such strength - or at least continuing to hold their existing long gold positions. This outlook might be based on the hypothetical premise that the US economy could deteriorate in upcoming months/years.

At the end of the day, whether a trader decides to enter the precious metals market is completely dependent on his/her own existing portfolio, strategic approach, outlook and risk profile.

Whatever the case may be, a recent episode of Closing the Gap: Futures Edition breaks down recent movement in the gold and silver markets, and provides an overview of the associated position structure for traders considering a Gold Silver Ratio mean reversion trade. This can be effectively be viewed as a contrarian trade (shorting gold into recent strength), while adding on the long silver part of the “pairs” trade as a hedge.

We hope you'll take the time to review the complete episode of Closing the Gap focusing on precious metals when your schedule allows. Traders that want to investigate other potential positions in the gold sector may also want to review this new episode of Market Measures, which outlines volatility-based trades in one of the best-known gold ETFs (GLD).

If you have any questions about this material, or any other trading topic, don't hesitate to leave a message in the space below, or reach out directly @tastytrade (Twitter) or support@tastytrade.com (email).

We look forward to hearing from you!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

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