(click for larger image)

A reader of mine (Jaytrader) brought up some good points about the relationship between gold and silver, so thank him for this post. Not only can you trade gold and silver outright, but you can trade the relationship between the prices, in this case, the quotient of the prices.

Jaytrader noticed that the price of the spread had been as high as 71 and has since decreased (I was going to say plummeted*, but I didn’t) to the mid 40s. Clearly, the ratio has been in a 3-4 month down trend.

Let’s look at what the quotient is and then we’ll look at how to position yourself for such a move. This quotient (Q) is comprised of dividing silver into gold, that’s it. Gold is about 1385 and silver is around 29.50, so 1385/29.50 = 46.

Now you’re not trading gold or silver, but the relationship between them. So what makes the quotient go up or down, that’s the question you ask yourself. Let Q = N/D, where N is the numerator and D is the denominator, the following solutions will arrive at a lower Q:

1. N and D both increase, but D increases at a faster rate

2. N stays flat and D increases

3. N decreases and D stays flat

4. N and D both decrease, but N decreases at a faster rate

To explain this chart, I believe that #1 is the solution, although all could be profitable. I caution you to look at the % changes in the individual commodities. The notional values of the contracts are close, but not exact. If the rates of change vary too much, you’ll need to offset the risk by using a ratio of contracts that is NOT 1:1.

gold = $1385 x 100 oz

silver = $30 x 5,000 oz

**Crude oil and natural gas**

You can also look at crude oil as it relates to natural gas, as in the chart below.

(click for larger image)

The relationship between crude oil and natural gas can be expressed like that of gold and silver, so I’ll spare you the details. If you want to go through it and email me what you think of how it’s done, I’d be happy to go over it with you.

* A word like “plummeted” makes the reader feel like someone’s lost a lot of money or that the price of a trading instrument decreasing in value is something to avoid. That’s not the case here. When you read anything in MSM, look closely for these types of words. Even if they’re used inadvertently, they oftentimes leave the reader walking away with a bias. That is poor writing.