For the spreadsheet discussed on the show, click here.
Silver is currently underperforming relative to gold and the Gold/Silver ratio, which tells us how many ounces of silver equals one ounce of gold has been increasing over the last five years and is at a relatively extreme level. What is the best way to take advantage of this situation?
Dr. Data, the head of our research team, came armed with a spreadsheet and took us through three ways of trading the Gold/Silver ratio using GLD and SLV. The metals can be traded via futures and futues options but we chose the ETFs.
The first is the simplest. It uses the stock only in equal dollar amounts so you might be short 100 GLD with an approximate notional value of $12K and long 800 SLV which also has an approximate notional value of $12K. The second method involves adjusting the notional values for implied volatility (IV). SLV has a higher IV than GLD. Mike explains how the calculation is done and if we were to put on this pairs trade we would still be shorting 100 shares of GLD, but buying just 600 shares of SLV.
The third method uses options. We still use the IV adjusted notional value but now are using at-the-money (ATM) options. Dr. Data takes us through the calculations again and we see that we would be selling 6 ATM SLV puts and selling 1 ATM GLD call. This helps us improve our cost basis by taking advantage of theta (time decay). Adjusting the notional values for IV and using ATM options can be applied to many other types of pairs trades too.
For more information on the Gold/Silver Ratio check out these segments:
Strategies For Your IRA: “Gold and Silver Ratio” from March 9th, 2015
Closing The Gap Futures Edition: “Using the Gold/Silver Ratio to Hedge /ES” from June 19th, 2015
Options Jive: “Pairs Trading Gold/Silver” from October 26th, 2015
Watch this segment of “Market Measures” with Tom Sosnoff, Tony Battista and special guest Dr. Data (Michael Rechenthin, Ph.D.), the head of our research team for the important takeaways, a valuable spreadsheet and an interesting twist on how to trade the Gold/Silver ratio and other pairs trades.
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