Tony: Welcome back my friend. Closing the Gap futures edition. Speaking of closing the gaps future edition, nice scalp of the oil futures. Bought at 84.16 just sold them 84.71.
Tom: Yeah, it was a quick little 55 ticks for the good guys this morning. In honor of …
Tony: Pete must be good luck.
Tom: … in honor of Pete being in the studio. Yes. How are you Pete?
Pete: I’m great. How are you, Tom?
Tom: See, in your honor, I just you know …
Pete: I think that's fantastic.
Tom: I want to thank the …
Tony: CME and the …
Tom: … I want to thank the CME, not for making me the money, but for facilitating the opportunity.
Pete: Liquid deep and transparent markets.
Tony: Well said.
Tom: Somebody was asking me the other day, they said, “Other than the S&Ps, where is the most liquid market for trading if you want to do something in the futures options? Well, this is easy. Right now, everything is about crude oil. You want to go to the most liquid market place right now. Every customer we have is trading in some capacity some form of crude oil. It's been on its butt. It’s been liquid.
Pete: The oil trades been great, it's liquid and the futures affording a 24 hour access, which is great. You can manage your positions really around the clock.
Tony: The calendar spread has been moving…
Pete: Yes it has.
Tom: So, before we get into today's discussion, which I'm really looking forward to, because it’s on all the markets that I'm trading right now, you'll also be out in San Francisco tomorrow. You'll be speaking for a little bit after I’m done and all that kind of stuff, right?
Pete: I will be, yes.
Tom: Awesome.
Pete: Looking forward to it.
Tom: So, if anybody wants to come on out, Pete will be out there all day if you want to meet him and talk futures markets. One of the cool things about these events is that CME is one of the sponsors, and so Pete goes out … Listen, nothing is off limits with him. I’ll put that out for you, okay?
Pete: That's excellent.
Tom: Nothing is off limits. One of the problems is that people have trouble getting to somebody that is an expert in a certain field. You have 20 years training experience, you run education at the CME, if nothing is off limits, it’s a very cool opportunity for people to pick your brain.
Pete: Yeah, I’m looking forward to it. The guys who come, it’s such a great audience too. They're engaged, they want to learn. You know what? That's what we’re there for [inaudible 00:02:13].
Tom: You want to hit them up with some hard questions. Bring your toughest question. Don't hold back, don't say, “Blah, blah, blah,” go for the kill. Why not?
Pete: Absolutely, looking forward to it.
Tom: That makes you feel good.
Pete: It does. It’s exciting to see them embrace and start to get a better understanding of the products.
Tom: The stuff we're covering today, I’m just going to tell you this, the stuff we are covering today, no futures discussion, in the history of futures education, on a retail level … On an institutional level maybe there's three or four hedge funds guys that do this kind of stuff from [inaudible 00:02:48] to different currency based train and stuff like that. In the retail market place this stuff is rare as hell and what we are about to do right here, which is our 7th or 8th time we are doing this … This is fascinating to me. Hedging Gold with Silver and Euro. Who has that discussion?
Tony: None that I’ve ever seen.
Tom: None that I’ve heard. The first thing I said to Pete this morning is, I love this because, I have a position on gold, I have a position on silver, and I have a position on euro. I am now ready to have this discussion to figure out what I am going to do with this discussion today …
Tony: Or at least figure out how weighted you are one way or the other.
Tom: So we are really looking forward to this, Pete, so thank you so much. Ready?
Pete: I'm ready to go.
Tom: The Gold and Silver ratio. The gold and silver ratio tells you the number of ounces of silver it would take to purchase one ounce of gold at a specified date. If you examine gold and silver prices going back 100 years or more, the historical ratio most commonly quoted is 30:1, where 30 ounces of silver would buy you one ounce of gold. I did not know that.
Pete: Yeah, and it’s been very consistent. It was pegged for a long time, and it’s been very consistent for that up to about 12 or 14 years ago. Then we saw the dynamic of a dramatic change in that gold/silver ratio. We saw it out to … well we’re seeing close to the highest right now. We saw it to about 85 a year and half ago.
Tom: So, let's think. Where is it now? Silver is about 17 and a half?
Tony: 17 and a quarter.
Tom: So, where is this ratio now?
Pete: About 72
Tom: Wow
Pete: Yeah
Tom: So, one of the things we talked about today is because silver is down this year twice as much as gold. So it’s 72 right now … We're not saying whether gold or silver is expensive or cheap, we are saying that relative to each other, silver is cheaper than gold.
Pete: Yes. It’s very interesting because it has spent a lot of time this year at 65, 68. We're now pushing 72 in recent 12 month highs.
Tom: The ratio, you mean.
Pete: Yes, the ratio is. This is a great way to look at and take some of the noise out of trading metals is using the trading the ratio spread. It lets you sit through some of the volatile …
Tom: [inaudible 00:5:03] reduces risk?
Pete: Right.
Tom: Beautiful. What would …? Well we’ll get to that in a second. I’m sure it’s in here. Changes in the Ratio. Over the past 12 years, the ratio had held closer to 60:1, meaning that it takes 60 ounces of silver to buy one ounce of gold. In the past 3 years, the ratio has fluctuated from 35:1 to 85:1, driven by volatility in prices of the metals themselves. That is a huge range.
Pete: It is, it’s a very big range. It is a unique set and it’s actually, to look at it through this lens, is again, is demystifying, and being able to a better sense of what is driving this overall relationship. Because you will find that one of these products tend to drive the other one, and by looking at the spread and looking at the ratio you sometimes get a better sense of which leg is the driver and where the outrights are going to go. This is a great tool if you are going to trade it as a ratio. It’s also a great tool if you are going to trading one of these products to get a sense of direction.
Tom: We get the question all the time, “Which should we trade? Gold or silver if we’re bullish?” The answer we have used recently is, “Well, silver is down twice as much as gold.” I never liked that answer as much as I like the answer, “Listen, the ratio is between 35:1 and 85:1 over the last three years. It’s currently trading at 72. It’s been averaging close to 60. Okay, you make your own call.” Then, it’s easy.
Pete: Yes.
Tom: You're buying silver. We just did a trade the other day where we did gold versus silver on premium selling ratio, very similar, but we will get into that. Gold and silver are both considered to be "precious" metals. However, gold is also seen as a form of currency and safe haven in times of political uncertainty, whereas silver is increasingly used as an industrial metal. These different fundamentals can, at times, make this a dynamic market to watch and to trade. So what do we have here Pete?
Pete: Here is the correlation between gold and silver. We see it’s got a very positive correlation. We look at the longer term correlation and it’s over 85%. We know that these are highly correlated markets that move in conjunction with one another. What we want to see is a highly correlated market that starts to exhibit price divergence like we’re seeing. That's very interesting because it's a fundamental change in how the market interprets the value of these two products.
Tom: What you're saying is this one month correlation of .68 is an extreme? Relative to where it is on a one year basis?
Pete: Right. Yes.
Tom: I think one of the things we love, our first opportunity is always based on volatility. But our second opportunity is always based around what we call price extreme. We're talking about staying small. We're talking about price extreme but when you see that, Tony -
Tony: I'm not as interested in trading it or looking for opportunity when it's August of 2012. You see something like you have now, in August of 2014; as a retail investor I say, "Okay. Maybe there's some opportunity there." That's what I'm looking for. Opportunity.
Tom: We're all trying to digest some valuable information but when you look at this, you see a one year correlation of .86 and you see a one month correlation of .68. You're looking at that thinking, "Damn. That is opportunity." I got it. I love this stuff. What do we have here? The size of the contracts?
Pete: Here's the size of the contracts. Basically, they're [notional 08:41] contracts because if we're going to start to look at … This is where the trade becomes foggy … We start to look at how we're going to structure our expression of … We could say the spread is broken out and we could see it print 75 or 80. We could look at doing this any number of ways, either buying gold and selling silver, or if we're looking at an extreme, selling gold and buying silver. But the first thing we need to do to get a true expression of that, and take out the noise and the underlying movements, is to understand the notionals and then wait the spread. We've done different versions of this before but again -
Tom: What is the most common version of this? What is the most common spread if you were to do gold versus silver?
Pete: It's three to two, roughly. The math works out really nice right now.
Tom: Three silver to two gold?
Pete: Three silver to two gold.
Tom: How do you quoted that? Gold over silver or silver over gold?
Pete: I usually do gold over silver.
Tom: It would be two to three?
Pete: Yes. Two to three.
Tom: I just want to get it right.
Pete: It's funny because I always think of it as three to two but it should be two to three.
Tom: It's gold … because you know what? I never -
Pete: Because we're looking at the ratio of gold over silver.
Tom: We've got the knobs for it finally down. We never knew what side we were reporting first. Now we know it's nose over buzz. We always call it the nose first. It's gold over silver so it would be two gold to three silver and you'd be long one and short the other.
Pete: Right. Part of what's interesting in this that is basically making equivalent notionals. We're getting purely exposure to the spread ratio, to the ratio of gold over silver. If we play with those tails, if we use two to two, we're actually taking a more bullish view on gold. There's ways you can use the spread to position within two different opportunities. Not only outright gold exposure, but then use the silver component to cushion a little of that.
Tom: If I'm watching -
Tony: Not cushioning. Because cushioning it would be two to three, right? If you go two to two, you're not cushioning. You're taking more of opinion on one or the other.
Pete: You're taking more of opinion on gold. But you're not taking just outright gold. You still have that silver component in it, but less of it.
Tom: What's the advantage of the discussion you had a second earlier, with the correlation? I thought the correlation of .68 was going to have some mean reversion towards the annual correlation of .86. I would be buying three silver and selling two gold?
Pete: Right.
Tom: Here, it's silver over gold but that's the three to two.
Pete: Yes.
Tom: Because it makes more since to say three to two. Beautiful. This is great so far. This is great. How does adding a dollar component /6E, you have to make this really complicated. How does adding a dollar component /6E to a gold/silver pairs trade, affect the pair’s relationship?
Pete: This is another way … We'll walk through it. Gold and silver are highly correlated. Gold and the dollar are highly negatively correlated. Gold and euros are highly correlated. Remember, when we talk about the dollar and talk about foreign currency, if we're long a foreign currency, we're actually short dollars. Every currency transaction has two sides to it, whether it be being long dollars and short yen, where we'd be buying the yen. If we're going to use currency futures, we always got to remember that gold and currency futures have a strong positive correlation. What's interesting is silver and the euro doesn't have near as strong a correlation.
Tom: You're saying when gold goes up the euro goes up?
Pete: Right.
Tom: Okay. That's your strong positive correlation.
Pete: Yes. When gold goes up, euro goes up. When gold goes down, euro goes down. That correlation doesn't necessarily exist as tightly with silver and the euro. We would think they would because gold and silver are so highly correlated. Why wouldn't they both be correlated the same way to euro? Well, they're not. By identifying something that is not co-linear … You guys have done such great pieces on correlations, r squared … Actually when you lay this out in a multivariate way, we get a model. You can get some interesting dynamics about -
Tom: If I have this correctly … This is the stuff I love … It must be so cool for you to finally talk about this stuff on a level where you're not, "This is a future," … You know what I'm saying? "This is what happens." This must be cool for you.
Pete: It's one of the things I truly look forward to.
Tom: What you're saying is, if I like silver vers. gold, then I might like silver vers. euro, too?
Pete: Really what you want to do, the way I'm prefacing is, you think gold and silver have a reversion aspect to them. That they're in an extreme. If you add a euro component to this, if you buy gold, sell silver, buy gold, and buy euros you're creating -
Tom: A tighter spread?
Pete: A tighter spread and it has a higher r squared to it. It's actually more correlated to the linear [Crosstalk 13:43].
Tom: I'm bullish on euro, I'm bullish on silver, and I don't care about gold. You're saying this is my time?
Pete: [Crosstalk 13:49 - 13:51] This could be your time.
Tom: That is my assumption.
Pete: I'm saying with that assumption, yes.
Tom: This is my time to shine. Because that's my position right now anyway. Gold has a high negative correlation to the US dollar which translates to a positive correlation to /6E. When the US dollar rallies or the euro future fails, gold's appeal as a safe haven diminishes. But what's interesting is even though gold and the US dollar have a strong negative correlation, gold and silver are highly correlated, which is what you just said. Silver and the US dollar do not have that strong correlation. I’m just repeating what you explained. You've perked my interest. Now I have to learn what the ratios are. That's the hard part. The euro … go ahead.
Pete: The euro notional, the euro contract is 125,000 euros and the notional is roughly 158,000 dollars. There's several ways to, quote unquote, skin this cat. How are we going to weight this? We could use euro futures as part of our … What we're prefacing is the idea that the reversion is even better or more solid if we sell gold, buy silver, and buy euros. Now we can add the euro, in and of itself, as a separate trade or we can take some of the silver out of the trade and make the spread silver and euros against gold. There's a number of ways we can do this. If we go to our three to two ratio, we can actually use two silvers and one euro but we actually notionally add too much euro value to it. I actually like looking at this as doing the gold/silver asset two to three ratio spread, adding the euro component, and adding one euro contract as a long.
Tom: I'm setting it up here as you're talking. That's what I'm trying to do. Give me the ratio. Let me go to the next page.
Pete: This slide just highlights the fact that the gold to euro correlation is appreciably higher than the silver to euro correlation.
Tom: Give me the actual Fuscous correlation right now. What am I doing?
Pete: You would want to -
Tom: Give me the minimum spread correlation.
Pete: You'd want to sell two gold.
Tom: So I'm selling two gold.
Pete: You'd want to buy three silver.
Tom: I'd want to buy three silver. That's the original ratio. And I'm going to buy one euro on top of that?
Pete: You're going to buy one euro on top of that.
Tom: I'm going to show you the beautiful thing about today's technology. I can set this whole thing up. I can push one button and I'm filled on all three. I set that up as a pair’s trade. Remember, it's not a single-price fill. That's going to three separate marketplaces. I didn't pick pennies with any price or any of that sort of stuff. I did that live. I did all three of those underlyings. I bought three silvers, sold two gold, bought one euro.
Tony: Silver is 17.28 -
Tom: It doesn't matter. These are all tight markets.
Pete: A great thing on a toss platform, too, is, using thinkScript, you can actually chart this ratio. You can do gold over silver then add, and then divide the sum of those two by the euro component. You can actually chart this ratio then compare it against a straight gold/silver ratio spread.
Tom: I got enough problems right now.
Pete: It's a very interesting way to start to get your mind around how this works.
Tom: I just filled the order. Tony now come up with -
Tony: You did the ratio two silver, sorry, two gold, three silver, one euro.
Tom: I did. Unfortunately, we don't have all the programming in yet to get the actual max reduction in buying power, so I did the minimum trade; two three by one. What I wanted to show people is everything we discuss here is investable. It's actionable. With a single click on this technology, a single click … Because I set the trade up, went to blast all, a single click routed all three orders simultaneously and I was filled within one second. I was actually probably filled within a few milliseconds but the messaging comes back in about one second. That is what's cool. Let's keep going here so we don't run out of time. Why does silver have a weaker correlation to the dollar than gold? As you've written here, it comes back to silver's dual nature as both an investment metal and an industrial metal. Gold may have plenty of appeal as a store of value for inflation hedge but has few real-world industrial applications, unlike silver, where it’s used, silver is used in everything.
Pete: Over 55 percent of silver consumption is for industrial use. It's consumed. It's not just held.
Tom: When silver had its crazy run, you started listening to all these things about … Things normalize. I hate to get back to the same subject but what happened with silver is it got out of control for a year or two. Then it normalized. Then it went the other way, like everything does. Because they go the complete opposite direction. What we're hoping for is some form of normalization over the next year in all three of these underlyings.
Pete: Yes.
Tom: Beautiful. If you believe gold is overvalued rather than silver, you want to sell gold, buy silver, and buy the euro FX, paying for the euro FX in dollars, which we just did. Since gold and silver move together and gold and the dollar move apart, inverse correlation, there's an added measure of safety built in, which extends our duration and reduces our risk. In this case, it just uses a little more capital. Man, Pete, this is great. What do we have here?
Pete: This is the trade we just did. This is broken down as to … One of the things I wanted to talk about, without having a span margining, without margining across the products, it can be a more expensive trade in terms of buying power.
Tom: This 33,770 dollars is the overnight requirement. Intraday, it would be less. To be fair, we're not talking about this as an intraday trade.
Pete: Right. One of the things I did on the next slide is I … To soften it up in terms of the cost and the buying power effect, is to add … We're going to get exposure in the euros by selling some puts. We get a little bit of a credit. We're margined on that credit but we get a little bit of a credit. We can actually, by selling two euro 1.26 puts, with a total delta of 80, we're actually perfectly sizing that against the trade.
Tom: You're not saving any money on margin but you're adding a theta component, which if you have high IV on the euro, which we talked about earlier today, which is still in the mid-seventies, as IV rank, which is extremely high. Even though the euro volatility is low, the IV rank is high.
Tony: That would be a good set up for an -
Tom: Adding a short put component as opposed to the future itself, which I just didn't have time to do this morning, would have probably been another way to approach this. One other thing to mention, if you use the options in here … But I got to tell you the gold, the silver options … These options are tradable for sure. Not my favorite in silver but the gold options and the euro options are definitely tradable but you can get smaller.
Pete: Yes, you absolutely can. The CME has made a big commitment to make sure that that liquidity is there during the entire trading session. We've actually seen a lot of growth in those volumes. They're making really good -
Tom: Anytime you use options instead of futures … These are futures options, but any time you use these, just like Pete said, you can use the same ratio but get your delta significantly smaller. You can take a ton of risk out of the equation by reducing size via options. That's for another whole discussion. We're already over. You have blown us away today with all this stuff. It is a lot to just listen-
Tony: It's a lot to digest.
Tom: It's a lot to digest.
Pete: It is.
Tom: Because we've got our minds in fifty different places.
Tony: That's what this is all about, right? That's why we have the segment. To give us something different.
Pete: You guys are doing such a great thing. The segments you did this week on correlations are [Crosstalk 21:59 - 22:00] beta and r squared are fantastic.
Tom: No. Those were great.
Tony: Pete, thank you so much for coming in. We appreciate all your time here. We're going to take a quick break. We're going to come back -
Tom: I'll see you tomorrow.
Pete: Looking forward to it.
Tony: Come back in 90 seconds. This is tastylive live.