tactics

SPECIAL SECTION: Luckbox is devoting this month’s tactics section to techniques for pairs trading, courtesy of the Learn Center at tastytrade

Trading the Gold-Silver Ratio

Here’s the simplest way to reduce portfolio volatility by pairs trading the two heavy metals

By Anton Kulikov

In the world of pairs trading, the gold to silver ratio ranks as one of the most popular trades because of its stable correlation and tendency to diverge in price. What does all that mean to traders? The gold to silver ratio serves as a less-risky way to trade precious metals while engaging in fading short-term price extremes.

Luckily, today’s technology and a wide array of financial products make it possible for anyone to trade the gold to silver ratio, regardless of the size of the account. Let’s explore the simplest method of trading this pair: the priceweighted ratio.

But first, a quick disclaimer: This is just one method of trading this pair, but it also happens to be the simplest way possible.

At this writing, the price of the SPDR Gold Trust (GLD), the exchange-traded fund (ETF) that tracks the value of gold, is approximately $149.00. The price of iShares Silver Trust (SLV), the ETF that tracks the value of silver, is $16.50. To trade this pair, divide the price of GLD by the price of SLV and procure approximately nine shares of SLV to one share of GLD. The current ratio (price of GLD divided by price of SLV) is 9.0, meaning that it’s on the higher end of its historical range.

Next, the trader has to decide which one to buy and which one to short. Because the price of gold is relatively inflated compared to the price of silver, it makes sense to short one share of GLD and buy nine shares of SLV.

Keep in mind that the chance of making money on this trade is the same as trading GLD or SLV outright. The benefit of this trade, however, is that it reduces portfolio volatility by roughly 50% compared to trading GLD or SLV outright.

The capital required for this trade would be around $300 for every nine shares of SLV and one share of GLD traded. That makes the trade scalable for accounts of all sizes. A margin account is required for this method of trading the ratio because the investor is shorting stock. Check out the Advanced Tactics article in this month’s Luckbox for more ways to trade this pair.

Anton Kulikov is a trader, data scientist and research analyst at tastytrade. @antonkulikov97

A wide array of financial products enable nearly everyone to trade the gold to silver ratio—regardless of portfolio size.

Pairs Trading with Futures

For a pairs trade, find two highly correlated assets that have recently diverged in performance

By Michael Gough

Pairs trading involves buying and selling related markets to capitalize on performance disparities. Traders can use the strategy to reduce outright risk, diversify a portfolio and find new trading opportunities when markets seem recalcitrant.

To structure a pairs trade, look for two highly correlated assets that have recently diverged in performance. Find two related products because outright losses in one position will be offset by gains in the other position. Two such products are gold and silver. Investors can use the same gold to silver ratio pairs trade described in the Basic Tactics article in this series with futures to realize immense cost savings.

Experienced traders might consider using futures to trade the gold to silver ratio because of their capital efficiency. Exchange-traded funds (ETFs) often require 100% of their notional value—which means size or underlying value—in margin, but traders can achieve the same exposure with futures for only 10% of their notional value.

In other words, $100 of ETF exposure requires $100, while $100 of futures expo sure requires only $10. Investors can use those cost savings to hedge a portfolio, make shortterm speculations or contribute to long-term investments.

Before jumping in, consider the subtle differences between ETFs and futures pairs trades. When calculating the notional value that determines the proper ratio of each leg to buy and sell, traders should consider each product’s contract specifications.

While no one can perfectly hedge a pairs trade, adjusting by the volatility helps equate the risk on both sides of the trade.

Unlike ETFs, where the notional value is equivalent to the price of the product, futures have more-nuanced notional values. Gold and silver represent a classic case because one gold contract controls 100 troy ounces of gold, while one silver contract controls 5,000 troy ounces of silver. Therefore, an extra step that considers these subtleties is required to compute the proper trading ratio.

Besides considering the contract size, traders should adjust each product’s notional value by its volatility to derive a more accurate pairs ratio. While traders can never perfectly hedge a pairs trade, adjusting by the volatility helps equate the risk on both sides of the trade.

Failing to incorporate volatility can result in accidental over or under exposure to one market, which effectively defeats the purpose of pairs trading. Thus, to calculate the volatility-adjusted notional value of gold and silver futures, apply the following formula:

Volatility Adjusted Notional = Number of Troy Ounces x Price Per Ounce x Implied Volatility

As of this writing, that equates to:

Gold Volatility Adjusted Notional = 100 x 1,589 x 11% = 17,479

Silver Volatility Adjusted Notional = 5,000 x 17.86 x 18% = 16,074

These volatility-adjusted notional values reveal the proper pairs trading ratio for a gold and silver pairs trade is one for one. If after looking at the gold to silver ratio traders believe the ratio will increase, they can buy one gold future and sell one silver future. Vice versa, if they believe the gold to silver ratio will decrease.

While the number of troy ounces per gold and silver future is unlikely to change, prices and implied volatilities are dynamic and should be recalculated before entering a new position.

Besides reducing capital requirements, incorporating futures can add a level of opportunity that’s unattainable with ETFs. While there are liquid ETFs for gold, silver and the major index funds, several other exciting markets—such as foreign exchange, interest rates and agricultural products—are accessible only with futures.

Some popular products and their volatility-adjusted notional values are listed in “Volatility-Adjusted Notional Pairs Trade Ratios,” left. Michael Gough enjoys retail trading and writing code. He works in business and product development at the Small Exchange, building index-based futures and professional partnerships. Learn more about pairs trading with futures here

Trending Together

Many stocks tend to move in tandem, so pairs trading enables investors to mitigate directional exposure

By Michael Rechenthin

Investors might consider using pairs trading when they feel bullish or bearish on a stock but want to reduce exposure to the daily movement within the market. In other words, it’s well known that stocks tend to move in tandem—they tend to go up or down in price at the same time. Pairs trading enables investors to be more non-directional and make money on the relative value of the investment—making money in up and down markets.

For example, an investor might think Caterpillar (CAT) is undervalued compared to the overall market. While Caterpillar is up a few percentage points over the past year, the Dow Jones (DIA) is up 15% over the same period. In this case, the investor might go long Caterpillar and sell an equal dollar amount of DIA. That’s a strategy that professional traders have been using for years, and usually these trades take a few days to a few weeks to play out. Occasionally, investors keep these trades for a few months.

With the price of DIA more than twice the price of CAT, traders would need half the shares of DIA to gain a hedge—for example, 134/294 = 0.46. But another more advanced way of trading stocks and exchangetraded funds (ETFs) incorporates the different magnitudes of movements into the ratios. It’s called “volatility-based pairs trading.”

Notice the one-year percentage change of CAT and DIA in “Tracking volatility,” above. CAT is considerably more volatile than DIA. That means the hedge needed to reduce risk will be greater than just looking at price.

To use “volatility-based pairs trading,” investors need two numbers for each symbol: price and implied volatility. Implied volatility can be captured from an advanced trading platform such as tastyworks.

Caterpillar, as a percentage, has a much larger expectation of movement because it has a larger volatility than the Dow—nearly double. But the price of Dow Jones is more than double the price of Caterpillar.

Follow the steps below to determine how many shares of the hedge are needed. First, multiply the symbol by the last price and then by the implied volatility. That provides a theoretical expected move of the price over one year—either up or down.

Thus, Caterpillar is expected to move by 134 x 25% = 33.5, either up or down over one year. While the Dow is expected to move by 294 x 15% = 44.1, either up or down over one year. Second, divide the amount that Caterpillar is expected to move by the amount that the Dow is expected to move.

Thus, 33.5 / 44.1 = 0.75. That means investors need three-quarters as many shares of the Dow (compared to Caterpillar) as opposed to only half if investors didn’t take volatility into consideration. The pairs trading ratio differences are even more dramatic when the change between the volatilities are larger.

So, adjusting for volatility means that an investor has a more appropriate hedge for risk. That helps lower daily change in price between the pairs. It’s something to consider when trading two symbols.

Michael Rechenthin, Ph.D., (aka “Dr. Data”) heads research and data science at tastytrade. @mrechenthin

Pairs trades usually take a few days to a few weeks to play out. Occasionally, investors keep them for a few months.

“Whatever you do, don’t go near it, Billy. This is the portal to the Dark Web.”