Longtime tastytraders, especially those that follow the precious metals space closely, are probably well aware of current levels in the Gold-Silver Ratio. That’s because it’s been trading for some time at what we like to call “a price extreme.”
For background, the Gold-Silver Ratio is a metric that many traders monitor for insights into the precious metals space. Specifically, this ratio can serve as an alert to traders that a breakdown may have occurred in the “usual” price relationship between the two metals.
Pairs traders often look for breakdowns in long-standing correlations between two different underlyings assets (referred to as price divergence), because these instances can at times transform into attractive opportunities in the marketplace. However, a potential pairs trade always starts with the establishment of strong correlation between the two underlying symbols/products/markets under consideration.
For example, over the last 100 years or so, gold and silver have traded with a positive correlation of about 0.89. Given that 1.00 represents a perfect positive correlation, it's clear that gold and silver have been connected at the hip in terms of price movement.
Looking at the current precious metals market, we can see that the price of gold is about $1,286.60, while the current price of silver is $14.53 (5/16/19). Using those figures, the Gold Silver Ratio currently stands at $1,286.60/$14.53 ($gold/$silver) which is equal to 88.5.
Over the last one hundred years or so, the Gold-Silver Ratio has ranged between roughly 15 and 100. However, in the last 20 years, that range has narrowed to more like 50 and 90. That means, at 88.5, the Gold/Silver Ratio is very close to its recent historical highs, and probably worth monitoring going forward.
Moreover, futures traders aren't limited to only gold and silver when considering opportunities in the precious metals marketplace. In addition to gold (/GC) and silver (/SI) futures, traders can also follow and trade platinum (/PL) and copper (/HG) futures, as outlined on a recent episode of Futures Measures called “Detecting Metals in the Market.”
Platinum and copper are of particular interest because the prices of these metals also exhibit a strong positive correlation with gold and silver, as well as to each other.
As noted earlier, gold and silver have exhibited on average a positive correlation of close to 0.89 through their long history. It may surprise you to hear that the correlation they share with platinum and copper is only slightly lower.
The information below highlights the average correlation between these four metals (from 2018):
Correlation of Gold with Silver/Platinum/Copper since 2018
Correlation of Silver with Gold/Platinum/Copper since 2018
The first thing that sticks out in the above numbers is that the correlation between gold and silver has dropped below its historical average in recent months - from 0.89 to 0.84. That change may help explain why the Gold-Silver Ratio increased so much recently. Breakdowns in correlations are usually associated with price divergences and associated price “extremes” - as observed with the Gold-Silver Ratio pushing the upper limit of its recent range.
Another important takeaway from the above data is that silver has been trading with a higher degree of correlation to platinum and copper when compared to gold’s relationship with those two metals. That may be due to the fact that silver, platinum, and copper all are widely used for industrial purposes, while gold is not.
No matter the reason, the fact is these four metals all share an undeniable correlation, and one that meets the threshold for consideration when it comes to pairs trading. Pairs traders usually look for a correlation of 0.70 (or higher) between the prices of the two underlyings before giving any serious consideration to a potential position.
The correlation data above therefore suggests that traders investigating potential pairs trades in the precious metals space can also consider pairing gold/silver against platinum (or even copper). The current price per ounce of platinum is about $857.
Like gold and silver, traders can utilize the Platinum-Silver Ratio to monitor “price extremes” (i.e. price divergences) for potential trading opportunities. For added context, the Platinum-Silver Ratio has ranged between roughly 37 and 150 over the last 30 years. The current value of the Platinum-Silver Ratio is about 58.
While you may not be comfortable immediately deploying a trade in metals futures, it is possible to monitor the prices of these metals (add them to your watchlist) or even mock them. Mock trading allows us to learn more about how a given trade performs/behaves without the risk of capital losses.
To learn more about how to deploy a pairs trade in the metals futures space, we recommend reviewing this previous installment of Futures Measures entitled “Setting Up the Gold-Silver Ratio Trade,” as well as the aforementioned episode covering the platinum and copper correlations with gold and silver.
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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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