By Jason Pearce

The Ratio Is Ready to Rumble

Gold and silver are highly-correlated. Making a bet on the direction of one of these metals is, by default, betting on the same direction in the other. As a matter of fact, silver is often referred to as “poor man’s gold” because you can buy it at a substantially cheaper price and it still exhibits the same trend as the yellow metal. If you overlaid the price charts of gold and silver and take off the price scale, you’d have a pretty tough time determining the difference between the two.

Gold Silver overlay monthly

Despite the moniker, silver is a great trading candidate for the “rich guy” as well. I would even go so far as to say that silver is the choice of the “smart guy” when prices are rising. This is because silver tends to move at a faster speed than the gold. And during a bear market, shorting silver is the choice of the “really smart guy”!

The faster speed means that silver outperforms gold during a bull market. Conversely, silver drops faster than gold during a bear market. This means that the ratio between gold and silver tends to rise in bear markets as gold retains its value better and the ratio declines in bull markets as the silver outperforms.

Gold weekly

As proof, look at what has happened during this multi-year bear market in precious metals. Gold peaked at an all-time high in 2011 and declined nearly 46% into the December 15th multi-year low. During this period, the gold/silver ratio went from just below 32:1 to 80:1. That means it took thirty-two ounces of silver to buy one ounce of gold in 2011 and it now takes about eighty ounces of silver to buy that same ounce of gold.

Gold Silver ratio weekly

Gee, that sounds like a tradable spread to me. The $64,000 question is: When should you get in? That’s quickly followed with another question: At what price should you get in? Here’s an attempt to answer that.

The Ratio: Then and Now

In 2014, the gold/silver ratio hit a four and a half year high of 70:1. This caught my attention. I wrote in a blogpost in September 2014 that “The last two times that the gold/silver ratio climbed to a multi-year high of 70:1 was August of 2002 and again in September of 2008. Both times, the ratio accelerated higher. The ratio surged to 80:1 by early 2003 and it rocketed to 84:1 in the fourth quarter of 2008.

Longer-term, these accelerations were the tail end of a move that preceded a major reversal. From the 2003 high of 80:1 the ratio plunged to a multi-year low of just under 52:1 in just over ten months. From the 2008 high of 84:1 the ratio plunged to a multi-year low of just under 59:1 in eleven months.

Either we should now be at the top of the gold/silver ratio and the bottom of the multi-month decline in precious metals…or else we are at the point where there is a blow-off acceleration in the ratio while gold and silver plunge to new multi-year lows.”

As it turned out, the ratio surged to 80:1 over the next eleven months. After making a sharp break into the October 2015 low, the ratio recovered and is back up to either side of 80:1 right now.

Ratio Resistance Levels

The 80:1 ratio level is worth keeping an eye on. On the weekly nearest-futures chart, the ratio peaked at nearly 85:1 back in October 2008. This was during the depths of the financial crisis. Prior to that, the ratio peaked at just over 80:1 in May 2003, which was not too long after the end of another bear market in equities. The ratio peaked just under 86:1 in February 1995.

Can the ratio go higher from here? Sure, it can. I just told you that it hit 85:1 in 2008 and 86:1 in 1995. Heck, it even made to a record high of 101:1 in February of 1991 when silver was at the bankrupting low of three and a half dollars-per-ounce. But the probabilities are that the ratio has reached a major top or it is at least very close to one.

Is the Third Time the Charm?

The last two times the ratio got to 80:1 on the nearest-futures weekly chart, it did not stay there very long. The ratio nearly hit 80:1 (close enough!) in February of 2003 and made the final high four months later. The following spring it was down below 52:1.

The ratio reached 80:1 again in October of 2008, peaking at a thirteen and a half year high of nearly 85:1. It spent most of the fourth quarter flip-flopping either side of 80:1 before it finally decided to head south and not look back. A year after the top, the ratio was down to 59:1. A year and a half after that, the ratio was trading below 32:1 for the first time in over three decades.

Gold Silver ratio weekly (80-to-1)

Now that ratio has reached 80:1 for the third time this millennium, the smart money should wager on a reversal. Because the ratio often declines during a bull market, the implications are that the multi-year bear markets in gold and silver should be coming to an end as well. Is it any coincidence that gold rallied from near a multi-year low to a twelve-month high since the year started just six weeks ago? Or that gold closed above the weekly 100-bar Moving Average last week for the first time in about two years? Last year’s high was established after gold rallied into this same weekly 100-bar MA and rolled over. Perhaps last week’s successful breakout is a strong tip-off that the bull market has started.

Translation for Futures Traders

To capitalize on a potential decline in the gold/silver ratio, a trader can create a spread between one 100 oz. gold futures contract and a combination of one 5,000 oz. silver futures contract and three 1,000/oz. ‘mini’ silver futures contracts. This would pit 8,000 ounces of silver against 100 ounces of gold, which is a ratio of 80:1.

The June-July gold (100 oz.)/silver (x8,000/oz.) spread is currently at -$2,000. This means that the value of 100 ounces of gold is at a discount of $2,000 to the value of 8,000 ounces of silver. The high for this spread was set last August at -$688. The nearest-futures spread hit +$132 at the same time, which briefly put the premium on gold. This was the first time that gold had the premium on this spread since 2008. It lasted for one whole day.

Downside Potential

October 2008 marked the high for the nearest-futures gold (100 oz.)/silver (x8,000/oz.) spread when it topped at a fifteen-year high of +$3,830 (premium gold). This occurred during the depths of the financial crisis. The gold closed at a premium several times during the fourth quarter of that year. However, the longest sustainable streak for the premium on gold was five consecutive days and silver still closed with the premium about two-thirds of the time (44 out of 64 trading days). The point is that this spread can’t seem to sustain a premium on gold. A reversal may be around the corner.

Gold (100 oz.) Silver (8,000 oz.) spread daily (2008)

Naturally, one would want to know what sort of downside action the gold (100 oz.)/silver (x8,000/oz.) spread is capable of. This would give you an idea of what sort of targets to shoot for and help traders determine potential reward-to-risk ratios on trades.

Gold (100 oz.) Silver (8,000 oz.) spread daily decline (2008-2011)

After peaking with the premium on gold in 2008, the spread declined to a record -$233k (premium silver) by 2011. This broke the prior record of -$218k in 1980. However, these two events occurred during historic bull markets in precious metals. We probably shouldn’t get our hopes up on something like this occurring again in the near future.

Gold (100 oz.) Silver (8,000 oz.) spread daily decline (2003-2006)

The spread did descend to -$60k (premium silver) a few years after the 2003 top was established. This sort of downside seems a bit more realistic.

Gold (100 oz.) Silver (8,000 oz.) spread daily decline (1996-1998)

Finally, the most anemic analog for the gold (100 oz.)/silver (x8,000/oz.) spread may be the drop to approximately -$28k (premium silver) a year and a half after the gold peaked with a premium in 1996.

Targets as Per the Ratio

We can also use the gold/silver ratio as a potential guide for where the gold (100 oz.)/silver (x8,000/oz.) spread could be headed when it finally turns over. The past is not a guarantee of the future, of course, but it can show you where the path of least resistance is located.

-Following the peak at 86:1 in 1995, the ratio experienced a three-year bear market that took it to approximately 41:1.

-Following the eight-year high of 80:1 in 2003, the ratio experienced a three and a half year bear market that took it to just under 46:1.

-Following the thirteen and a half year high of nearly 85:1 in 2008, the ratio experienced a two and a half year bear market that took it to a multi-decade low of less than 32:1.

So, guessing that the gold (100 oz.)/silver (x8,000/oz.) spread will top out either side of ‘even money’…and that the ratio could head below 50:1…and that a drop in the ratio will be accompanied by a rise in the price of precious metals…the conclusion is that the gold (100 oz.)/silver (x8,000/oz.) spread could be heading on down to -$81k (premium silver) over the next few years.

Wait. What?!

That’s right, I came up with -$81k (premium silver) as a target for the spread if the ratio hit 50:1. With gold trading around $1,238/oz. right now, silver would have to hit $24.76 to get the ratio to 50:1. Since silver is currently around $14.66 it would have to rise $10.10/oz., which is an increase of nearly $81,000 on 8,000 oz. This might even be a conservative estimate, too. There are for two reasons for this.

First, we’re talking about a ratio of 50:1. That’s still higher than where it eventually landed during the previous three bear markets (bull markets in precious metals).

Second, I was calculating as if silver moved up while gold prices were flat. The ratio tends to drop when metals are rising, so it’s most likely going to happen while gold is on the upswing. Therefore, silver prices will have to go even higher to get the ratio down to 50:1. If gold rose to $1,500/oz. and the ratio was at 50:1, silver would have to hit $30/oz. This would put the difference between 100/oz. gold and 8,000/oz. silver at -$90k (premium silver). Now that would be something worth trading!

Technical Observations

Right now, the June-July gold (100 oz.)/silver (x8,000/oz.) spread is just a stone’s throw from the mid-August spike high of -$688. This is obviously price resistance. A peak either side of last summer’s high could establish a double top. A sharp breakout above it, followed by an immediate reversal lower, would trigger a Wash & Rinse sell signal. This failed breakout pattern could be even more bearish than a double top.

June-July Gold (100 oz.) Silver (8,000 oz.) spread daily

Furthermore, the spread has closed above the rising 50-day Moving Average every single day for more than three consecutive months. This is bullish. However, a two-day close below the rising 50-day MA (currently around -$4,417) for the first time since early November would be a bearish event that traders could use as an indication that the run is over.

History always repeats…sometimes

Brian Fantana once said, “sixty percent of the time, it works every time.” I like to think that the method of using history and technical analysis for trade selection and market timing is a little bit better than that. Still, even if we could be right on 99% of all our trades, that one percent could kill our trading careers if it’s not managed well.

We know that the gold/silver ratio has been unsustainable above 80:1 the last couple of times it made it to such nosebleed levels. This tells us which way to bet.

But markets occasionally rewrite history. Therefore, it is important to have some sort of preset criteria that tells you to abandon ship when that the improbable is happening and that your bet is losing. You can always get back in later. Risk management is what allows you to always comeback and fight another day, no matter how bloodied you got in today’s scuffle. Therefore, don’t even think about getting short until you’ve figured out where you’ll bail out if you’re wrong.

By Jason Pearce

Has the Wheat Crop Flip-Flop Stopped?

About a month ago, we posted a watch list of various inter-market spreads that offered trading opportunities. It was based on the criteria that the spreads between several correlated markets had reached price boundaries that were historically extreme. Some of the spreads had already rolled over and were fair game; some were still trending in outlier territory and should be closely monitored. All of them had a history of making sizable reversals.

In the grain sector, the relationship between Kansas City and Chicago wheat caught our attention. The price of the KC wheat dropped below the price of Chicago wheat back in late June. This set things in motion for a buying opportunity. You know the old disclaimer that’s going to be inserted right here: Past Performance Is Not a Guarantee of Future Results. However, good trading is about probabilities, not prediction. Therefore, I would submit to you that Past Performance Can Tell You Something About the Probabilities of the Future.

History shows that anytime the price spread between Kansas City wheat and Chicago wheat inverted it has always been followed by a recovery. So we’ve been keeping an eye on this spread since the inversion. Recent price action suggests that a recovery from the summer price flip-flop could finally be underway. This may be the green light we needed for spread traders to get positioned on the long side.

Paying For Quality

The price difference between the wheat contracts in Kansas City and Chicago is not due to the location of the exchanges, it is based on the differences in the types of wheat for the underlying futures contracts. The Kansas City wheat contract is for hard red winter wheat and the Chicago wheat contract is for soft red winter wheat. The protein content of hard wheat is higher than that of the soft wheat. It is considered to be of a higher quality, so it normally trades at a higher price.

Although we are looking at two different types of wheat here, the price correlation between these two crops is extremely high. When you superimpose the price charts of Kansas City over the Chicago wheat, you’d be hard-pressed to spot the difference between the two. This high correlation between the two markets makes for a ‘safer’ spread trading candidate. ‘Safer’ is a relative term, though. When you are dealing with leveraged futures contracts, there’s always risk involved. But risk management and strong correlations in spread relationships help to mitigate the risks.

Kansas City Wheat Chicago Wheat overlay (nearest-futures) weekly

Despite the higher quality, the price premium of the Kansas City wheat over the Chicago wheat is not a locked in guarantee. This is because there can occasionally be changes in the supply and/or demand of one of the crops that does not impact the other crop as much. So one of the contracts may rise or fall faster than the other. This has been the case for this year.

The Inversion of 2015

Ample supplies around the globe and multi-year highs in the US dollar have weighed heavily on the entire wheat market this year. This was merely a continuation of the multi-year bear market across the entire grain sector. However, there was a temporary run-up this summer when the soft wheat growing region was hammered by a deluge of rain. This occurred just before right before the harvest as the seeded area was already below the five-year average.

The price decline continued when the second half of the year started and Kansas City wheat moved down at a faster rate than the Chicago wheat. Ergo, the spread price inversion. The government resumed their projections for global grain supplies to reach new all-time highs before the next North American harvest. This week’s new multi-year high in the US dollar only serves to reinforce the bearish outlook.

Vulnerable Shorts

Despite all the gloomy news about abundant grain stocks and the strong greenback, the wheat market may be vulnerable to a rally right now. According to the recent weekly Commitments of Traders report, speculators have increased the size of their net short position in the Kansas City wheat rose for six consecutive weeks. This is the longest such bearish streak in four years. Furthermore, the size of the net short position is the largest in nearly a decade.

These short positions are speculators that we are talking about. They don’t actually have the physical wheat to deliver against the contracts that were sold short. Should any of the CTAs or hedge funds decide to do some short-covering as we approach year end, it could result in a sharp rally that triggers program-buying (buy stop orders) by other speculators. This may have a domino-effect and continue pushing prices higher as more and more buy orders are triggered by higher prices. The KC/Chicago wheat spread would likely soar on the turnaround. Any bullish change in the underlying fundamental picture would only add fuel to the fire.

Know the Boundaries

Just like in healthy human relationships, it’s important to know where the boundaries are at in spread relationships. When boundaries are tested or crossed, the balance of things will be upset. Something big will happen. In spreads, this usually means that a reversal is inevitable.

Kansas City Wheat Chicago Wheat ratio 1.2 (nearest-futures) weekly

At normal levels, Kansas City wheat should have a price premium either side of 10% over Chicago wheat. When that premium climbs to 20% or more, then it’s time to pay attention. The KC wheat has only reached a premium of 20% or more over the CBOT wheat about half a dozen times in the last four decades and it never lasted. Therefore, if you even see a +20% markup on the KC wheat you know that the KC/Chicago wheat spread is a prime candidate for a short sale.

Conversely, when the Kansas City wheat loses its premium over the Chicago wheat it’s a warning shot for traders. In the event that the Chicago wheat reaches a premium of 5% or more over the Kansas City wheat, it’s time to get your game plan (and your capital) together for an opportunity on the long side of the spread.

Kansas City Wheat Chicago Wheat ratio 0.95 (nearest-futures) weekly

For Chicago wheat to surpass a 5% premium over Kansas City wheat, the KC/Chicago wheat ratio has to drop to 0.95:1. The ratio has only been this low two times in the last ten years and not even a dozen times in the last four decades. The inversion was always temporary. Inevitably, things would play out and Kansas City wheat would go back to have the normal 10% premium (or more) over Chicago wheat. In spread terms, KC wheat would get back up to a 35 to 40 cent premium over Chicago wheat.

Darkest Before the Dawn

In late June, the nearest-futures KC wheat closed below the price of the CBOT wheat. This was the first spread price inversion in three years so we immediately put it on the watch list. The spread rebounded in the second half of July, but it was never able to get back above the ‘even money’ mark. It just settled into a trading range for the rest of the summer.

Kansas City Wheat Chicago Wheat spread (nearest-futures) weekly

A month ago, the nearest-futures December KC/CBOT wheat spread left the trading range and plunged to a new eight-year low of -40 1/4 cents (premium Chicago) on the daily timeframe and -33 cents (premium Chicago) on the weekly timeframe. The spread has only been this upside down on three other occasions since 1970. This is a big deal. The more infrequent that the price levels have been hit, the more potential the spread has for a major move. By all accounts, there was nothing to stop the KC/CBOT wheat spread from sinking to the September 2007 capitulation low of -61 1/2 cents (premium Chicago). The relationship was coming under fire.

Turning On a Dime

Despite the new multi-year lows in early November, the spread has since made quite a turnaround. More impressively, this occurred in the face of new contract lows in both the Kansas City wheat and the Chicago wheat just this week. It is quite possible that the spread has finally bottomed out.

Further evidence of a turnaround is the behavior of the spread itself. First of all, the March KC/Chicago wheat spread ended the month with a close above the declining 75-day Moving Average for the first time in six months.

March Kansas City Wheat Chicago Wheat spread daily

In addition, the spread has rallied nearly 25-cents from the November 5th contract low. This is the biggest rally in fourteen months. It is also the longest rally since the bounce off the December 2014 low. This ‘overbalancing of price and time’ is indicative of a trend change. Based on history, the KC/Chicago wheat spread may now be on its way toward +40 to +50 cents (premium Kansas City).

Outside Confirmation (Just In Case You Need It)

Coincidentally, Societe Generale is on the same page as us. Although they recently lowered their average price forecasts for several ag markets, the bank actually raised their price expectations for soft red winter wheat. Moreover, they stated that they expect the Kansas City wheat to go back to trading at a premium of 7-10% over the Chicago wheat in the first quarter of 2016. Perhaps the analysts are students of history. Perhaps they read our research.

What to Do Now

It’s time to get long. Simply put, spread traders should be buying Kansas City wheat contracts and shorting the Chicago wheat contracts.

For entry points, you might want to consider buying a pullback of 8-10 cents. This idea is based on the current price structure: During the multi-month decline off the May top, the March KC/Chicago wheat spread made several bounces of ten cents or more. During the recent one-month rally, the spread has made a pullback of six and a half cents and another pullback of nine cents. Therefore, countertrend moves of 8-10 cents appear to be good entry opportunities.

Seasonally, the KC/Chicago wheat spread has a tendency to soften in the second half of December. Buyers can use this to their advantage by scaling into a position if the pullback materializes.

March Kansas City Wheat Chicago Wheat spread (even money line) daily

The November 5th contract low of -26 cents (premium Chicago) is an important line in the sand for the March KC/Chicago wheat spread. A close below this price would indicate that the recovery is in jeopardy. Therefore, it would be prudent to use such an event as a liquidation signal for long positions. Take the hit, get to the sidelines, and wait for a recovery signal before you reenter.

Even if the KC/Chicago wheat spread plunges to new lows before the year is out, it should eventually rebound. Unfortunately, we don’t have a crystal ball that tells us how low it will go first before that happens. Every record low price in history was made when the previous record low was broken. You don’t want to be held hostage in a long position during those sorts of events. Cut your losses if the spread between the hard red wheat and the soft red wheat dips into the red. You can make it all back once it’s in the black.

By Jason Pearce

The Industrial and Precious Metals Connection

Despite the fact that there are different fundamentals that drive the demand for industrial metals and precious metals, there still appears to be a link between the price trends in these two sub-sectors of the metals category. If one were to take a very macro view, perhaps this price correlation is due to the fact that trends in inflation and economic growth impact both.

Using gold as the representative for precious metals and copper as the representative for industrial metals, a long-term price chart of the two reveals two things: First, gold and copper to tend to move in the same direction a majority of the time. Second, it shows that the copper market tends to be more volatile and sensitive to price swings than gold.

Gold Copper overlay (nearest-futures) monthly

It makes sense that copper reacts to fundamental trends more quickly than gold. After all, the global gold supply is so large that the annual production and consumption changes equates to somewhere around one percent of the total supply. It’s almost as if most of the gold in the world simply gets transferred back and forth from the vault of one country’s central bank to the vault of another country’s central bank. Therefore, the value of gold is much more likely to be shaped by interest rates and inflation expectations rather than noticeable swings in actual production and consumption.

Copper, on the other hand, is used explicitly for industrial consumption. More than two-thirds of the world’s red metal goes directly into building construction and electronics. As goes the construction industry, so goes the copper market.

Ugly and Getting Uglier

Both precious and industrial metals have been in bear markets for well over four years now. Slow global economic growth and a lack of inflation have been weighing on both sectors.

Gold (nearest-futures) monthly

With the threat of an interest rate hike from the Fed looming over the market and the US dollar at the highest level in many years, gold continued to push to new multi-year lows this week. Since central bank monetary policy tends to run in trends, the outlook is that the eventual rate hike from the Fed could be the first of many. If not, it would only be because the US economy is now growing at a fast enough clip. Either way, this is not supportive for gold.

Copper also continued its downward spiral as China is now experiencing the slowest economic growth in one-quarter of a century. Since they are the world’s largest consumers, the slowdown is creating a serious glut as copper supplies get stockpiled in the warehouses. There doesn’t appear to be any light at the end of the tunnel, either. Goldman Sachs is forecasting that the oversupply will last until at least 2019.

Copper (nearest-futures) monthly

The current fundamental outlook does not bode well for any commodity traders who are trying to buy a bargain in the metals right now. Furthermore, with both gold and copper tumbling to fresh multi-year lows, the reward-to-risk scenario down here is not anything spectacular for short sellers. On the surface, it would seem that the best metals position for traders and investors to get into right now is flat.

The Relationship between the Blonde and the Redhead

Because of the correlation between the precious and industrial metals, it only makes sense to examine the historic relationship between the two. This can reveal potential trading and investing opportunities that may not exist in the underlying commodities themselves. This is a major advantage that spread traders have.

Since both gold and copper topped at record prices a few years ago, looking at the ratio between the two markets will normalize the relationship and give us a true perspective on whether or not it has reached historically extreme levels during this bear market. We can do this via the futures markets by dividing the value of a 100-ounce gold contract by the value of a 25,000-pound copper contract.

Gold Copper ratio (nearest-futures) daily

As it turns out, the ratio recently pushed above 2:1 and surpassed the January high. It is now matching the 2011 peak. This is a significant event. Over the last twenty-five years, the ratio has only been at 2:1 or higher on a few occasions and the financial crisis was the only time it has been considerably above this level. Therefore, we know that the gold/copper ratio has reached an important inflection point.

Far-Reaching Implications

We believe that the gold/copper ratio is at a do-or-die level. If it follows the normal course, we should be looking for a reversal somewhere in this area. If so, it could put the ratio on course for a decline to somewhere around 1.2:1. To do so means that ‘Dr. Copper’ is finally outperforming gold. In all likelihood, this would occur if the world economy is making a rebound. Whether or not this will turn into a secular trend will be left to be seen, but it would mean that we’re at least getting some respite from the current overwhelming bearish environment for commodities.

Gold Copper ratio (nearest-futures) weekly

The reversals off the peaks in 1993, 1999, 2003, 2009, and 2011 allowed copper to outperform for periods of roughly one and a half years to three years. Therefore, a trend reversal in the gold/copper ratio sometime soon would imply that traders should be positioned on the long side of copper and the short side of gold (on a spread basis) through 2016 and beyond. Furthermore, it should be a supportive factor for the China theme and for the commodities markets in general.

Coincidentally, the CRB index has now reached major price support as it has returned to lows similar to the bottoms in 1975, 1999, and 2001. A bottom in commodities in general reinforces the idea that the gold/copper ratio is topping.

CRB Index weekly

After bottoming out in 1975, the CRB index bounced, pulled back into a slightly higher low in 1977, and then launched a multi-year bull market to historic highs. Similarly, the index bottoming out again in 1999, rallied, pulled back into a slightly lower low in 2001, and then underwent another multi-year bull market that sent commodities to new record highs.

The takeaway here is that the raging bear market in commodities in general has reached a level that could potentially mark the end of the meltdown. If it follows the patterns of 1975-1977 and 1999-2001, commodities would make a sizable bounce in 2016, experience one more sizable pullback, and then it’s off to the races again. This pattern would dovetail nicely with the idea of a reversal in the gold/copper ratio and an improvement in the world economy.

On the other hand, a failure to reverse from here opens the door for the gold/copper ratio to surge another 50%. This would put it in the company of the 1980, 1987, and 2009 peaks at 2.95:1, 2.98:1, and 2.83:1, respectively.

Gold Copper ratio (nearest-futures) weekly

Based on the economic conditions of when these peaks in the gold/copper ratio were established, one would have to consider a continued rally from here to be a bearish omen for the global economy. With commodities already undergoing one of the longest bear markets in history and China, the world’s second-largest economy, sputtering along with the slowest growth in twenty-five years, the prospect of further surge in the gold/copper ratio is downright scary. It would indicate that the straw has broken the economic camel’s back.

Structuring a Spread Position

If you have both the capital and the stomach for trading futures, the simplest way to play relationship between gold and copper is to spread one 100-ounce gold contract against two 25,000-pound copper contracts. You want to have twice as many copper contracts because the nominal value is about half that of gold. Therefore, you create a more dollar neutral position by having a similar dollar amount of gold and copper.

Since the copper contract is priced in cents-per-pound and the gold contract is priced in dollars-per-ounce, you can simplify how the spread is plotted by calculating the difference between the value of the sum of two 25,000-pound copper contracts and the value of the 100-ounce gold contract.

You probably noticed that we are calculating the value of the copper first for the futures spread, which is inverse to how we calculated the gold/copper ratio. The reason for this is because a pair of copper contracts is normally worth more than one gold contract. Therefore, we like to quote and plot the spread where the market that usually shows a premium as the lead. Also, the spread chart will reflect the bearish trend seen in both the underlying gold and copper markets.

If you don’t have the risk capital needed to trade the futures contracts, the ETF market is another way you can trade the copper/gold spread. Be careful with the copper ETFs, though. While there is plenty of liquidity in the gold ETF, the copper ETFs are thinly traded.

JJC (x4) GLD spread weekly

The most liquid copper ETF is DJ-UBS Copper Sub-Index ETN (symbol: JJC). It is trading at approximately $23.90. At the same time, the SPDR gold ETF (symbol: GLD) is trading at approximately $102.90. This puts the GLD/JJC ratio at approximately 4.3:1. Therefore, a dollar neutral spread position would require that you purchase approximately four shares of JJC for every share of GLD that is sold short. As you can see, plotting a spread between four shares of JJC and one share of GLD looks similar to the spread between two copper futures contracts and one gold futures contract on the charts.

Historical Parameters

Historically, the spread between two copper futures contracts and one gold futures contract is in oversold territory once it drops to ‘even money’ or lower (where gold has the premium).

Copper (x2) Gold spread (nearest-futures) weekly

Consider what has transpired the last six times after the copper (x2)/gold spread inverted:

1993

Copper (x2) Gold spread 1993-1995 (nearest-futures) daily

The nearest-futures spread bottomed at -$1,020 (premium gold) in November of 1993. It then rallied for fourteen months into the January 1995 top at +$34,045 (premium copper). The gain was approximately +$35k per spread.

2002

Copper (x2) Gold spread 2002-2004 (nearest-futures) daily

On Boxing Day (December 26) of 2002, the copper (x2)/gold spread bottomed at -$90 (premium gold). It then rallied for a year and one-quarter into the March 2004 top at +$29,765 (premium copper). The gain was nearly +$30k per spread. After several months of consolidation, the rally continued and reached the record-shattering 2006 high of +$136,405.

2009

Copper (x2) Gold spread 2008-2011 (nearest-futures) daily

The 2008 financial crisis crushed the copper (x2)/gold spread. The capitulation point was reached when it breached the 1980 historic low and posted a new all-time low of -$29,380 (premium gold) in March of 2009. From there, the nearest-futures spread began a two-year ascent into the 2011 Valentine’s Day nadir at +$94,965 (premium copper). This rally of +$124k per spread was one for the record books.

2011

Copper (x2) Gold spread 2011-2012 (nearest-futures) daily

The spread inverted again in 2011 and bottomed out at -$8,730 (premium gold) in October of that year. A six-month advance into the April 2012 high of +$28,295 (premium copper) followed, sporting a gain of approximately +$37k per spread off the low.

2012

Copper (x2) Gold spread 2012-2014 (nearest-futures) daily

In November of 2012, the copper (x2)/gold spread dipped just below ‘even money’ and established the bottom at -$815 (premium gold). From there, it worked its way higher into the 2013 New Year’s Eve top at +$51,845 (premium copper). That’s a little over +$52k per spread in thirteen months.

2015

Copper (x2) Gold spread 2015 (nearest-futures) daily

This year, the spread inverted in January. It bottomed out at -$4,615 (premium gold) by the end of the month. This led to a sizable rally into May Day where it topped at +$29,125 (premium copper). The three-month bounce of +$33,700 per spread was certainly an event worth trading this year.

More Food For Thought

We’ve established the fact that the gold/copper ratio is at a potential make-or-break level. We also told you how to structure a position if you want to trade it. Here are a few more things that a futures trader might want to consider when approaching the current situation.

First of all, the gold/copper ratio has reversed from current levels more often than it has broken out. It seems that the way to bet with the probabilities then is to look to trade a reversal. If you agree, you will initially want to get positioned long in the copper and short the gold.

Next, we have to keep in mind that there were a few occasions where the copper (x2)/gold spread plunged substantially below the ‘even money’ waterline before finally bottoming out. This should make a trader bit wary of trying to catch a falling anvil by picking the bottom down here. Look for some sort of evidence of a price reversal. At the very least, make sure the downward momentum is slowing noticeably before jumping in.

From a time perspective, the current inversion is getting quite mature. It has been a little over three months since the copper (x2)/gold spread inverted and there has been no sustainable rallies yet. In the last twenty-five years, the longest period where the spread flip-flopped either side of the ‘even money’ mark before taking off was 4 months and one week. This occurred during the depths of the financial crisis. The other five durations of oscillating either side of ‘even money’ before the train finally left the station was one day (in 2002), one week (in 2012), one and a half weeks (in 2015), six weeks (in 1993), and 2 months and one week (in 2011). From a time perspective, one might think that a turnaround in the copper (x2)/gold spread may be close at hand.

Resistance levels

There are three resistance levels I’m currently monitoring for the March-February copper (x2)/gold spread. A breakout of any of them could be used as an entry signal on the long side. They could also be used to scale into a position by entering on the first breakout, adding on a second and raising protective stops, etc.

The ‘even money’ level is an important marker for the spread. The March-February copper (x2)/gold spread closed below this level for more than a week and counting. Therefore, a close back above this level could be a clue that it’s ready to start a move to the upside. It would be kinda like pushing a volley ball under water and seeing it pop back above the surface when you take your hand off.

March-Feb Copper (x2) Gold spread daily (even money mark)

A rebound from here would be even more compelling since the spread is probing important price support at the January low. Could a double bottom-type formation mark the end of the bear market in the spread? Better yet, how about a Wash & Rinse low (failed breakdown) to trigger program and algorithm selling before it finally makes a sustainable upside reversal?

March-Feb Copper (x2) Gold spread daily (late Sep-early Nov tops)

A close above ‘even money’ would allow the spread to take a shot at price resistance between the similar highs of late September and early November at and +$5,650 and +$5,790, respectively. A breakout above this price barrier would alter the current price structure and add some confirmation to the turnaround.

March-Feb Copper (x2) Gold spread daily (100-day MA)

Finally, the declining 100-day Moving Average is another technical resistance level that you may want to keep tabs on. Since peaking out on May Day and closing under the 100-day MA in mid-June, the March-February copper (x2)/gold spread has not been back above the 100-day MA yet. The bounces in mid-September and early November both stalled out just below this technical barrier. Therefore, a two-day close back above the 100-day MA (currently near +$5,000) would be another indication of a bullish trend change in this spread.

Economic Weather Patterns

Whether or not you trade the spread between gold and copper, the ratio between these metals will still serve as a key barometer for other trades and investments. Traders and investors alike should be paying close attention to how this plays out.

A further surge in the gold/copper ratio and a corresponding collapse in the copper (x2)/gold spread would be reason to seek shelter. A storm is coming. You will likely want to be positioned defensively or short in such conditions. Conversely, a reversal from here would offer a great buying opportunity for traders and tell investors that there are blue skies ahead in the forecast.

The gold/copper ratio will serve as your economic radar, so be sure to check it often. Just like the weather, market trends can change quickly.

By Jason Pearce

A High Energy Seasonal Spread

Energies are an important sector of the commodity markets as they have one of the most widely-felt impacts on the global economy. The price of crude oil is used as a bellwether of inflation. This is why you may see the price of oil quoted in many market news reports. Heck, even the non-traders among us notice how much gasoline prices can fluctuate throughout the week. Driving by the local gas stations every day can prompt plenty of comments at the water cooler later on at the office.

Interest rates, currency exchange rates, shipping costs, the economy, war, and politics can influence the price of crude oil. Just as importantly, the tail can wag the dog as crude oil prices can influence interest rates, currency exchange rates, shipping costs, the economy, war, and politics! This makes the energy markets important for hedging. It also means that energies offer great opportunities for speculation.

In addition to crude oil, one can also trade the crude oil products: the RBOB gasoline and the ultra-low sulfur diesel fuel (ULSD). Furthermore, you can trade the inter-market relationships between all three markets. Right now, there may be a trading opportunity shaping up between gas and ULSD.

Energy Product Price Correlation

Even though the usages are different, gasoline and ULSD are highly-correlated in respect to how their prices move. If you removed the labels from the price charts of gasoline and ULSD and superimposed one of them over the other, you’d be hard-pressed to pick out the differences. This makes them ideal for spread trading.

RBOB Gasoline ULSD overlay (nearest-futures) monthly

Just so you aren’t surprised, you may want to know that the ultra-low sulfur diesel fuel (ULSD) was previously a heating oil contract. However, the only different is the sulfur content. In compliance with changes in the EPA rules for distillate fuels, the contract specs were changed from 2,000 PPM (sulfur content) to a mere 15 PPM. This happened back in the spring of 2013.

As far as price behavior goes, it appears that nothing has changed. Many ‘old-timers’ still refer to ULSD as the heating oil market. That’s certainly good news for those trading on seasonal patterns and historic inter-market relationships.

It’s Time to Get Crackin’

This week is the start of a strong seasonal pattern for the spread between RBOB gasoline and ULSD (ultra-low sulfur diesel). Until early January, gas should be able to outperform the ULSD market.

Counter-intuitive…Or Is It?

Fundamentally, one would think that the price of heating oil –I mean, ULSD- would heat up as winter approaches because of the dropping temperatures. In addition, one might expect gasoline to stall out because driving should be on an overall decline (going to Grandma’s house on Thanksgiving is the big exception, of course). So shouldn’t we be buying the ULSD contract and shorting the gasoline?!

The fact of the matter is that everyone knows the seasonal expectations for demand. It ain’t rocket science. However, the job of the futures markets is to anticipate and price in the expectations for the future.

The refiners start cracking the crude and stockpiling heating oil long before the cold weather actually arrives. They continue to operate at capacity, which means they are not making as much gasoline. Therefore, the heating oil inventories are usually plentiful by the time winter actually gets here. Barring unusual weather extremes like a Polar vortex, the heating oil prices can then be on a downward slope once Christmas shopping season arrives since there is plenty of supply to meet the demand.

Historical Boundaries

If one were to look at the last thirty years of price history, it would appear that there’s no real trend in the ratio between RBOB gasoline and ULSD. Therefore, the prudent strategy would be to sell when the ratio is near the high end of the historical range and buy when the ratio is near the low end of the historical range.

RBOB Gasoline ULSD ratio (nearest-futures) weekly

On the low end, the gasoline/ULSD ratio becomes a candidate for purchase after it drops to 0.85:1 or lower. This has only happened about a dozen times (basis the nearest-futures) in the last three decades. Each occurrence was a temporary event.   Therefore, you should look for a setup to get long when the spread is in the tank.

Current Technical pattern

The March 2016 gasoline/ULSD spread has been in an uptrend since just before Labor Day. As a matter of fact, one could even argue that the spread bottomed nearly a year ago. After a sizable correction during the whole month of August, the uptrend continued. The spread is still in a bull market.

March 2016 RBOB ULSD spread daily

At the end of October, the March 2016 gasoline/ULSD spread cleared resistance at the July price peak of -17.36 cents (premium ULSD). This was a bullish breakout. Now that it has been cleared, the July peak has become a price support level. A pullback to somewhere around the July top should be viewed as a buying opportunity.

The ratio looks bullish as well. First of all, there’s the double bottom that was established between the December 2014 and August 2015 lows just above 0.83:1. This set the foundation for a bull market.

March 2016 RBOB ULSD ratio daily

Secondly, although it has already risen from the August low, the current ratio of just under 0.89:1 is still historically cheap.

Be aware, however, that this observation is made on the nearest-futures price data. Because the seasonal patterns are partly baked into the price, you don’t always see the prices in the expiring contracts and the distant month deliveries converge. Notice that the April 2016 ratio is already priced at 1.03:1 because of the expectation that demand for gasoline is higher after the heating season ends in the March/April timeframe.

Jumpin’ Jack Flash

We know that right now is the time of year to get long the March 2016 gasoline/ULSD spread. This is a seasonal trade with a high hit rate. We also know that the technical structure of both the spread and the ratio is bullish. This reinforces the outlook for a higher price.

Given the fact that the spread is currently in a pullback from the recent new contract high, spread traders could have an opportunity to quickly add to a long position. The seasonal play calls for getting long on Tuesday. The setup for an ‘add-on’ position would be to buy another spread on a close above the November 9th contract high of -13.17 cents (premium ULSD). You could risk the ‘add-on’ position to a close below the November correction low that precedes the entry. This allows you to really step on the gas if you have a winning trade on your hands.

Just like the commodity itself, trading a gasoline or ULSD futures contract can be both risky and volatile. Handle with care. You should know your risk tolerance and determine your position size before you jump in…or else your account could be gone in a flash.