Gold price looks overbought – is it time to trade the gold-silver ratio?

In our previous note on dollar-denominated gold, we were looking for a long position in the precious metal after identifying a large bullish chart pattern, known as a falling wedge (see chart below).

Over the last two weeks, a break above the $1295/oz level would have triggered the suggested trade, with $1325/oz and $1345/oz the upside resistance targets, which have now both been realised (see chart below).

Where to next for gold?

The upside breakout and subsequent move to test the high at $1345/oz moved the price of gold back into overbought territory. From here we see the price of the precious metal starting to correct. The long-term trend does, however, remain up. Trend followers might consider using the short-term correction as an opportunity to find long entry into gold, in line with the longer-term uptrend. This entry opportunity may be considered on a pullback towards horizontal support considered at the $1300/oz level. Should the correction, however, extend past the dotted trend line, our bullish bias to trades on gold would have to be reassesed.

Another way to trade gold

While the price of gold has had a good short-term run, traders hoping for a pullback for long entry may consider another trading methodology which involves the precious metal, i.e. a pair trade against the price of silver.

The gold-silver ratio (a pair trade setup)

The blue line on the daily chart below shows a ratio between gold (the numerator) and silver (the denominator) from 1984 through to today (12 June 2019). When the line is rising it shows the price of gold to be outperforming the price of silver. When the line is falling it shows the price of silver to be outperforming the price of gold.

The parallel black lines highlight a mean and two standard deviation moves above and below the gold-silver ratio. The mean represents a central tendency to the relationship between the two metals, i.e. a normalised suggested value of the gold-silver ratio.

When the gold-silver ratio moves towards the two standard deviation level, which is currently the situation, the suggestion is that gold is becoming overbought relative to silver and perhaps that relationship between the two metals will normalise back towards the mean.

With this in mind, pair traders might consider using this scenario as a pair trading opportunity looking to place a short trade on gold against a long trade on silver. The aim of this type of trade is to arbitrage the relationship between the two metals and collating the net profit (in a favourable outcome) between the two positions.

A favourable outcome to the pair trade could manifest in one of three ways:

1. The price of silver rising while the price of gold falls (both long and short trades are profitable)
2. The price of silver rising faster than the price of gold rising (the profit on silver more than offsets the loss on gold)
3. The price of silver falling slower than the price of gold falling (the loss on silver is more than offset by the gain in gold)

A shorter-term view on the gold-silver pair trade idea

For a shorter-term trade view on the gold-silver relationship, traders may look to add a 200-day simple moving average (SMA) to the ratio with a two standard deviation line above and below the average.

The daily chart below, uses a relative strength indicator to create the ratio. Bollinger bands (with a 200 SMA middle line) have been added to the relative strength indicator to highlight the mean and standard deviation calculations.

The ratio trades above the upper Bollinger band at present, suggesting that gold is overbought relative to silver at present. A normalisation of this relationship is expected and the suggestion is for a short trade on gold and a long trade on silver.

Should the pair trade work out with the ratio moving back to the 200 SMA, the profit expectation (netting off both positions against each other) would be for a 4.9% gain. A stop loss would be considered should the pair trade move unfavourably amounting to a 4.9% loss. A risk reward of 1:1 is used as arbitrage trades (such as this one) is considered to have a higher hit rate than perhaps trend following systems (where a risk to reward ratio of 1:3 is preferred).