A fixed return strategy on Gold/Silver Ratio using Options

The Gold/Silver ratio measures the relative strength of gold price against silver price. It shows how many Kg of silver it takes to purchase one Kg of gold. An increase in ratio indicates an expensive gold against silver. When the ratio falls, Gold gets cheaper and might offer a better buying value.

An increase in the ratio may happen in two conditions, either Silver prices should come down much faster than gold or gold need to go up with a higher momentum and Vice versa. This correlation is creating arbitrage opportunities. The current year Gold/silver ratio has shown average volatility of 27% and 11% on a bi-monthly basis. That means you have an opportunity or risk of 2.7lacs rupees from a 10 lacs Investment.

Divergence

Trading with any pair like metals, index, or currencies the most crucial point to look at is the divergence in correlation prices of pairs or assets. An all-time high or low ratio is not giving any indication for a pair trade. Current year Gold has gone up almost 25% and Silver at 68%, a massive 43% difference, and this divergence is the key to trade.

Correlation

Gold silver correlation had an experience of moving 0.3 to 1.14 for the last 10 years in MCX futures. A normal correlation between 0.6 and 0.8 is ideal for trading since below 0.6, it is very difficult to believe a divergence or convergence is happening. Also, the pairs are moving with equal strength above 0.8 and cannot expect any divergence at these levels. So to select a ratio around 0.7-0.75 looks ideal for initiating a trade.

How to Trade?

We have futures and options contracts available for trading at MCX with different lot sizes. One simple way is to book futures (equal lots) or selling Gold OTM PUT option and Silver OTM CALL option with the above-mentioned conditions. This always carries a risk with an increased divergence. The other way is using options strategy since this time MCX has got contracts with the same expiry date 25-Nov-2020 as a near-month contract for the pair.

Select options and IV

Implied volatility (IV) has to determine the better option to trade and that is the key here. The more the IV rank more the probability of success for selling options. Let’s assume selling a GOLD OTM PUT option with strike 48000 and Silver OTM CALL with strike 68000 with underlying future prices as 50500 and 60500 respectively with a ratio of 0.83. This is not an ideal level to trade as explained but to show a sample. This strategy may give negative returns if ratios are not favoured as expected. To avoid such scenario hedge the trades by buying options. That is to Buy OTM CALL options for silver and PUT option for Gold with lesser and near strike price.

The strategy looks like an Iron Condor and provides protection from all types of fluctuation in the gold and silver. On expiry, the strategy makes a maximum amount of 24600/- from the above example and the Maximum loss is caped with the difference in option premium. Here it is below 7200 (Expense not added).

Gold and silver always move in the same direction but with different momentum. Traders can enter and exit with profit on multiples times with favoured conditions. The same concept can be applied by Selling Gold Put and Silver Call for a downtrend in the ratio.