Gold/silver ratio in the precious metals market

Previous studies have considered how the price ratio of two metals - copper and gold- can affect the quotes of world stock indices. Today, we will study whether it is possible to create an effective trading strategy based on the gold/silver price ratio.

The gold/silver ratio shows how many ounces of silver equals 1 ounce of gold at the current market price level. As a rule, during periods of economic growth, the ratio decreases, and during crises it grows.

In recent decades, the gold/silver ratio has been moving in a wide flat within 80 and 50, rarely going beyond these limits. Reaching the limits of the flat often signals a local high or low of quotes of one of the metals, which, with a high degree of probability, may be followed by a price reversal (and, as a result, the ratio itself) in the opposite direction.

Strategy

Entering the market - buying gold and selling silver at the opening of the next trading day, if the gold/silver ratio is less than the lower threshold (betting on a growth of the ratio).

OR

Entering the market - selling gold and buying silver at the opening of the next trading day, if the gold/silver ratio is above the upper threshold (betting on a fall of the ratio).

Upper threshold options: 80, 70, 60.

Lower threshold options: 70, 60, 50.

There are 6 upper/lower threshold options in total.

Exit from the market - a reverse transaction at the close of the trading day (if the first transaction is a buying, then exit through a selling, and vice versa):

• At the end of the next trading day after entry
• At the end of the 5th day after entry
• At the end of the 10th day after entry
• At the end of the 15th day after entry
• On the opposite signal, i.e. when the gold/silver ratio has become less/greater than the threshold, at the intersection of which a transaction was opened

The strategy will be evaluated according to the following criteria:

• The average rate of return reflects the relative change in the quotes of financial instruments in percentage. A positive value of the rate of return indicates the profitability of the strategy, a negative one indicates a loss. 

The average rate of return (R) of a financial instrument is calculated using the formula:

where:

n is the number of trades;

P (%) – the percentage of change in the quote of a financial instrument at the time of fixing a position, is calculated as follows:

for buy positions

P (%) = (position closing price - position opening price) / position opening price * 100%

for sell positions

P (%) = (position opening price - position closing price) / position opening price * 100%

• The total rate of return (TR) is the sum of the profits from all trades. The greater the value of the total rate of return, the greater the profit brought by the signal during its testing period. 

• Maximum drawdown (MaxDD) is the maximum loss in percentage terms from fixing unprofitable trades for the entire testing period. The lower the value of the maximum drawdown, the better the trading signal works.

where:

n – number of trades;

TRn – total rate of return of n trades;

DDn – drawdown at the time of closing the n-th trade;

MaxDD – maximum drawdown.

Analysis of the obtained results

The gold/silver ratio price chart:

It can be seen that the gold/silver ratio exit from the range of 80-50 is almost always impulsive (except for the period in the early 1990s). Accordingly, this is followed by a rather sharp return of the ratio back to the specified range. Let's see how effective a trading strategy will be, which is based on the premise of a regular return of the gold/silver ratio to the previously traded range.

For variable parameters, the following designations are used: 80 - 70; where:

80 (the first number) - the upper threshold of the gold/silver ratio. Possible values: 80,70,60.

70 (the second number) - the lower threshold of the gold/silver ratio. Possible values: 70,60,50.

The values of total rate of return and maximum drawdown are indicated on the left vertical axis

The values of average rate of return are indicated on the right vertical axis

The minimum acceptable level of average rate of return of 0.3% corresponds to a strategy with exit options on the 10th and 15th day after entering a transaction at any levels of the gold/silver ratio.

However, the maximum drawdown size when using this strategy is at a very high level. For the exit option at the end of the 10th day after entry, the maximum drawdown is in the range from 442% to 828%, and for the exit at the end of the 15th day from 614% to 1170%. Such a level of maximum drawdown does not allow us to consider the strategy effective, even despite the rather high level of average rate of return (up to 1.19%).

Next, consider the strategy’s results with exiting the transaction on the opposite signal, i.e. when the gold/silver ratio has become less/greater than the threshold, at the intersection of which a transaction was opened.

When exiting on the opposite signal, the strategy shows a high level of average rate of return: from 1.68% (levels 80-60) to 2.07% (levels 70-50).

The strategy shows a very low level of maximum drawdown: from 0.9% to 1.98%. This is achieved due to strict conditions for exiting the transaction: the potential loss is not fixed until the gold/silver ratio returns to the level at which the trade was opened. I.e. the position can be held for a long time (up to several years in some cases), exit conditions on the opposite signal make it almost impossible to close the transaction with a loss.

The downside of a high rate of return and a low level of maximum drawdown is that the appearance of signals for the transaction is rare. When exiting on the opposite signal, the strategy generates from 261 signals for levels of 80-50 (8 transactions per year on average) to 82 signals for levels of 60-50 (2.5 transactions per year on average). However, transactions with this strategy have a high rate of return with a very low level of maximum drawdown, so a long wait in this case is justified.

Detailed results are shown in the Appendix:

XLSX (0.06 MB)Gold-silver ratio in the precious metals market.xlsx