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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.

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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.

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The uptrend in gold has been broken, but that does not trigger an immediate short sale in anyone’s model. Typically, analysts will refer to a period of “distribution” where buyers and sellers of hedging and investing ilk will manage their positions.

They will look for the price to travel out of the distribution range to signify if a new uptrend results or a change in trend has occurred. Look at the chart below:

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The two horizontal lines represent where traders will be looking to see if gold can stay above these levels price-wise. If not, it may signify that a downtrend in beginning. These rules are pretty straightforward and are the easiest way to find a change in trend.

What’s most important to a trader though is how they trade the trend. Those collective techniques are as unique as your fingerprints and everyone trades the trend differently. What’s important is you find a way to do it that’s comfortable to you.

When I ask the legendary traders how the played gold in the late 70s, they all took giant chucks of the move. They didn’t buy it once and leave it go, they were constantly buying and selling the contract with a long bias.

I received this email and I thought everyone could benefit from these great questions. My responses are in bold.
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It’s hard to see how to get started as a prop trader, to make the transition from trading your own account to managing funds. It’s one thing to be competent but it’s quite another to get other people to trust you with their money. It’s just my opinion but most fund managers are excellent at the latter but not so good at the first whereas for some of us it’s the other way around. How do you get off the ground?

Supposing I’m off the ground some other things trouble me.

1. Suppose the best course of action at one particular time is to do nothing and wait or have some very light positions. People (clients) can become VERY impatient and demand action when none is called for. They can mistake this inaction for laziness, cowardice or incompetence when in reality it’s simply following a proven method.

You might be putting something into this that’s not really there. Of course it’s possible, but no one has ever mistaken my periods of no action as “inaction for laziness, cowardice, or incompetence.” It sounds like a retail brokerage client service model applied to a CTA paradigm of having full discretion.

Two things you can do are: 1) screen potential clients for how much time they’re willing to give you. If they cannot commit to 3-6 months to get used to your methodology before they sign the papers, then don’t sign them up in the first place. Two, if you do sign them up, also ask them when they’d be available for your monthly call. It’s a mistake on your part to want to talk to anyone about the markets more frequently than monthly. You are in control of this process, but you need to have the b*lls to draw the line with someone and if they threaten to not give you money, don’t take it. If you do, they will own you and it’s not worth it.

2. I read in one of your articles that SAC will reduce your funds if you lose 5% from your peak account. I lose that all the time. The only way to deal with that it seems is to risk 1/2% on 10 trades and lose all ten in a row. However, the return with such a small risk is correspondingly reduced. Do people really expect linear returns? If that’s so, I can’t do it. That’s something I just can’t deliver without putting winnings in the silo to pull out at the right time or other shell games, something I’m absolutely dead set against and will never do.

The rules for established traders at SAC and what your clients expect from you is likely large. My take is that as long as your monthly losses and drawdown are within your backetested results, clients will be ok with it.

3. People appear to want success from you right away. It’s not impossible to be an excellent trader yet be -3% right out of the starting gate. Yet that would put you 2% away from the kiss of death at SAC Capital. Maybe that’s extreme but Bill Dunn’s 15% drawdown and my 15% drawdown will be viewed and treated very differently. How should you deal with client/boss expectations in these cases?

Most traders have a kill switch in their trading that they set for themselves, so there is no “kiss of death,” as you call it. If you get to -10% per month, and you’re only 3 weeks into the month, you take the rest of the month off. You can set it for daily, weekly, or monthly percentage points.

Your clients don’t have an emotional track record with you. You set their expectations by leading with your worst performance and asking them how they would feel if this was their money? What would their behavior entail? If they said, “well, I’d be calling you everyday…” you can tell them “no thank you” because that is unacceptable behavior on their part. Let them log in to their accounts and they can see everything in real time, but incessant calling and emails are likely to do more harm than good and distract you. Your own clients will end up psyching you out.

One of my mentors has the following as his total client agreement:

1) I agree to follow my system.
2) I don’t promise to make you money.
3) Here is the fee structure….
4) …and if you call me more than 3 times a year, I will give you your money back.