Playing silver and Gold Futures against each other as the Gold/Silver Ratio nears "break out"...
In MY REFRIGERATOR, a jar of something called "sandwich spread" has been lurking for weeks, writes Brad Zigler at Hard Assets Investor.
I honestly don't know how it got there, but I suspect one of my Canadian friends...invited over for our backyard barbecues...brought his favorite along and then forgot to export it from our premises. I would have preferred him leaving some of his Molson behind. But that's the thing about this condiment, a combo of mayonnaise and pickled vegetables. You either love it or hate it. I know 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).
Take the Gold/Silver Ratio for instance. Breakouts in the ratio of Gold Prices to Silver Prices are a favorite of spread traders. So why not look at the trade through their eyes?
First, 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 Futures are 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. And if you think the gold/silver ratio will move in the white metal's favor (meaning it will fall, as gold becomes less costly in terms of silver ounces), then you might be inclined to Buy Silver.
Purchasing silver outright, however, means you're only going to make money if the price advances above your buy point. Using the futures market instead, in contrast, you can sell gold against a silver purchase, betting instead 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. This means that 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 Futures contracts. The clearinghouse grants a 50% 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 0.50 = $15,864
Now, 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, or as they decline, giving you a profitable return just as long as your short position in gold paid you more (or cost you less) than your long position in silver cost (or earned).
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. So what are the odds? Well, 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?
We can apply a little probability theory here to better visualize the odds:
- Over the past year, the average for the ratio was 64.5x;
- Volatility has been clocked at 21.4%, which means in effect 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% 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:
If volatility remains constant at 24.1%, your odds look like this...
However, the essence of a breakout is increased volatility. If there's a short-term spike, say to the 35% level, the odds look quite different:
You 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% volatility?
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. But all this has made me hungry for a sandwich...and a Molson.
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