HardAssetsInvestor

Written by Brad Zigler  |

September 08, 2010

Gold/Silver Ratio Traders Happy?

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Real-time Monetary Inflation (last 12 months): -1.9%

So, traders came back from their summer escapes yesterday (well, a lot of traders, anyway; the trading floor population will likely not come to full force until after the High Holidays). Business, as a result, picked up for precious metals. Gold and silver both were bid up—though the reasons for the buying befuddled some market observers. From talk among the trade, buying was pretty much just something to do.

No matter for gold/silver ratio traders, though. Things are working well for those bulls with a predilection for white metal. When we last examined the ratio ("How To Trade The Gold/Silver Spread"), an ounce of gold could buy 64.4 ounces of silver (basis the December COMEX deliveries). By yesterday's settlement, gold's multiple had slipped to 63.2x; gold's purchasing power had been whittled down a bit.

Let's define "a bit" more fully. Traders aiming for a narrowing ratio would have sold short two gold futures for every three silver contracts purchased. The spread, treated as a single entity by the exchange clearinghouse rather than two outright positions, gives traders the ability to make money whether metals prices rise or fall, just as long as the difference in their prices diminishes.

The relatively small contraction in the ratio has produced an open gain of $5,770 in the spread. That's a 36.4 percent return on margin. In answer to the headline question, then, I'd say yes, the spreaders favoring silver ought to be happy.

Gold/Silver Spread

The undercurrent here is that gold, although rising, hasn't exhibited the same vigorous momentum as silver. Let's not forget that silver tends to be more volatile than gold—its annualized standard deviation is 38.8 percent vs. gold's 23.7 percent—and that three trading days is hardly permanency.

But gold's momentum has been lackadaisical, even before September. Specifically, there's been a divergence in the direction of gold's momentum oscillator and its price trend since mid-August. Momentum has headed south while prices worked their way north.

Momentum is typically highest at the beginning of a trend and lowest at trend turning points. Any divergence in the price and momentum directions warns of weakness; if price extremes occur with weak momentum, it signals an end of movement in that direction.

Spot gold's momentum reached a nadir of -51.1 on July 27 when bullion was $1,161 an ounce. A peak of +61.1 was attained on Aug. 16 when gold climbed to $1,227. Now, even though gold has risen about $30 since then, its price momentum indicator has tumbled to +22.4. You can see this same pattern on the chart for the bullion-holding SPDR Gold Shares Trust (NYSE Arca: GLD).

And silver's momentum? Silver's indicator bottomed at -0.4 on Aug. 23, then rose like gold's (the apparent disparity in the size of the indicators is due to the fact that they're based upon the per-ounce price of the metals; the trajectory and the signage is more important than the absolute size of the indicator). The essential difference is that silver's momentum hasn't yet peaked.

Silver's indicator is at +1.53 presently, though strengthwise, it does look a bit overbought. And, yes, you can see this divergence replicated on the chart of the iShares Silver Trust (NYSE Arca: SLV), too.

So, all tolled—and told—there's the reason for ratio traders' smiles. Let's see how long they can remain happy.