Trading Idea for the Gold/Silver Ratio

11/11/2009 12:01 am EST

Focus: COMMODITIES

The gold/silver ratio is now in the vicinity of its 12-year historical average of 60, which also happens to be a couple of points above its current 200-week exponential moving average (EMA). This chart says so much, even though it's simply based on a Bollinger band set at three standard deviations (SD) away from a 200-week EMA. Note how frequently the 200-week EMA (center line, purple) has acted as a powerful reversal area on at least a dozen occasions since 2001; with the ratio hovering close to the 200-week EMA right now, wise metals traders will be watching to see if the recent move up in the ratio will carry to higher levels (which would be comparatively bullish for gold) or if the swing will stall, leading to a rapid plunge below this critical EMA support barrier. If the ratio does begin to move lower, breaking sharply below the EMA, there is a good chance that the ratio could embark on a sustained journey back toward the 200-year historical norms for the ratio – which is about 30:1. See Figure 1.

With gold at about $1,085 , that would equate to a silver price of about $36.17 per ounce, more than double the current cash price. Even a more modest move in the ratio down to 45:1 would generate a hypothetical silver price of about $24.11 per ounce. Of course, should gold and silver both move lower (also a possibility -- after all, this is the commodities market, where anything is possible) a decrease in the ratio would simply mean that the price of silver is declining more slowly than the price of gold. If you look at the 2008 spike higher in the ratio (left edge of the most recent green rectangle) from 52:1 all the way to 85:1 in a matter of only two months, you'd realize that the jump in the ratio was caused by silver's dramatic decline in relation to a less pronounced drop in the price of gold.


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FIGURE 1: GOLD/SILVER RATIO, WEEKLY.

It's not "magic," but it's interesting how frequently the 200-week EMA acts as support/resistance for the gold/silver ratio. Sharp breaches of the EMA, however, are typically followed by strong trending moves.

At present, both metals could be close to strategically important price levels from which major moves (up or down) may be expected to commence in the next few weeks. One reason for this is the recent Commitment of Traders (COT) data from the CFTC; commercial interests are holding near-record short positions in both metals, while large speculators (also known as large traders or hedge funds) are holding near-record long positions. It's looking to shape up into a Mexican standoff of epic proportions, and no matter which side wins, it would not be surprising to see either a substantial selloff or a major bullish breakout take place in the next month or so. If we see the bullish breakout, then wise metals traders would want to deploy a higher percentage of capital into silver rather than gold, especially if the gold silver ratio breaks below 60 on the ratio chart. Conversely, if gold and silver both start to sell off hard, it's very likely that silver will drop farther and faster than gold will, based on historical evidence.

How to play these ratios in the real world? Well, if both metals begin to sell off, why not sell an out-of-the-money (OTM) silver call, one that's highly unlikely to ever go in-the-money? And if both metals break higher, selling an OTM silver put beneath a major support level might be an especially profitable plan of action. The possibilities are many; those are just a couple of ideas that may get your creative juices flowing in preparation for what may be major moves up or down in the precious metals markets.

By: Donald Pendergast
More analysis from Don can be found at his Web site at http://www.chartw59.com.

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