How to Trade Futures Using Relative Value Market Analysis
For this article, we will focus exclusively on the commodities asset class. Within commodities, a relative value strategy capitalizes on short-term pricing differences of two commodities that have moved together directionally on a historical basis. The underlying philosophy of relative value traders is that no securities trade is isolated in a vacuum. As such, if two securities have been identified to have a reasonable degree of historical correlation, a sharp movement in either direction (upward or downward) of one of the securities opens up a short-term trading opportunity for the other security. This can be exploited to capture the profit from the pricing differential.
Silver-Gold Relationship During COVID-Impacted Markets
Once the effects of the COVID-19 pandemic started permeating into the financial markets, a fundamental divide began to occur between gold and silver prices which had historically moved closely with each other. More specifically, gold rallied while silver moved in the opposite direction. So what was the primary cause of this acceleration in the price of gold? In a nutshell, it was attributable to human psychology. As fear in the marketplace increases and investor confidence in assets such as equities and fixed income diminishes, investors undertake a flight to safety (also called a flight to quality).
This flight to safety concept essentially means that investments which are perceived to have a higher risk factor associated with them, such as equities, are sold. In contrast, “safer” investments are bought up in larger quantities. For years, gold has been seen as a ‘safe haven’ owing to its status as a store of value. This is because, unlike currency – which can be printed in theoretically limitless quantities – there is a limited supply of gold that can be dug up from the ground. As such, when investors believe that an adverse event is likely to cause an extended market decline, they start buying up gold, which then increases demand and, subsequently, pricing. As retail traders dive into the more liquid futures contract like Gold the less liquid Silver Futures found no buyers and subsequently plunged.
In the months following COVID-induced economic shutdowns around the world, investors started piling into gold. This exaggerated demand drove its price to an all-time high of $2074.88 in August 2020, as evidenced by the chart above. On the other hand, while silver is also negatively correlated with equities, it is not viewed to be as effective of a safe haven as gold. As such, increases in silver pricing lagged behind gold. Therefore, from a trader’s standpoint, it was clear that silver would eventually catch up to gold based on historical trends. While the timing and the degree of correlation were uncertain, traders who followed the relative value strategy were confident that silver would slowly but surely follow the trend of gold.
Soon enough, that is precisely what happened. If you track the gold (red line in the chart above) and silver (green in the chart above) price lines, you will notice them widening during the initial onset of COVID-19 (around March to April 2020) before starting to converge around May 2020. This difference between the two prices – called the ‘gold-silver spread’- highlights how the metals may break their historical correlative movement from time to time, but always end up reverting. That reversion is what relative value traders look to identify at an early stage and capitalize on to earn outsized profits.
Commodities During Times of Inflation
In October 2021, US inflation surged to 6.2%. This rate was the highest annual inflation in over three decades and even exceeded consensus economic forecasts of 5.8%. This inflation rate is attributable to multiple reasons, most notably the below:
- The US Government is increasing the supply of money faster than the rate of economic growth in the country. When central banks flood markets with liquidity at this pace, people and companies within the economy now have more to spend. In other words, more money is now chasing the same supply of goods and services, thus elevating prices.
- The US Dollar has recently been devalued, making imported goods more expensive to purchase.
This gives rise to the question: what happens to gold pricing when inflation rises? The short answer is that an increase in inflation causes a rise in the price of gold. During times of inflation, goods become more expensive, and the dollar becomes less valuable. As gold is denominated in the dollar, any increase in inflation leads to an increase in the pricing of the metal too.
For a relative value trader, this relationship presents a compelling opportunity. As investors sell riskier assets to buy gold and protect the value of their money, the price of gold rises higher at a faster pace. As we saw from the chart above, the gold-silver spread initially widens before coming together again as silver catches up to gold over a longer period. A savvy relative value investor will therefore know that as the Federal Reserve increases the money supply in the economy, the price of gold will inevitably rise due to the flight to safety. From there, the price of silver and other precious metals that are negatively correlated to equities will also increase, albeit at a slower pace. This lag presents an opportunity to capture potentially large profits.
As we anticipate inflation continuing to be a concern in the financial markets, we remain strongly bullish on the prospects of silver and continue to hold conviction in the efficacy of precious metals as a hedge against inflation.
Electric Car Revolution: A Catalyst for Copper
The proliferation of electric vehicles further affirms our bullish thesis on precious metals pricing both in North America and around the world. As carbon emission reduction becomes a priority for automakers and governments worldwide, electric vehicle (EV) adoption looks primed to continue its recent growth. In this new paradigm, copper will play a transformational role due to its usage in vehicle production and the broader infrastructure of EVs.
Based on the Copper Development Association research, hybrid and battery-operated vehicles use between 85 to 183 pounds of copper within each car based on its properties as an excellent conductor of electricity. As such, the greater adoption of EVs around the world spells excellent news for copper, and by extension, other precious metals whose prices correlate with that of copper.
How Can I Take Advantage?
We remain highly optimistic on precious metals prices, particularly, silver and copper, within the next 6 to 12 months. We anticipate that markets will once again demonstrate their historical tendency to gravitate towards safer assets such as gold in an inflationary environment. Based on the relative value trading strategy, this increase in gold will eventually translate into an increase in the price of silver. On the other hand, our copper thesis is driven more by positive demand-side dynamics of the metal stemming from the transition from internal combustion engines to electric vehicles.
There are several ways to increase exposure to these precious metals within a portfolio for traders looking to get in on the action. Based on their specific risk appetite and preferences, traders may opt to buy commodities futures, options or directly invest in the stock of companies mining and marketing these metals. All of the above are effective ways to capture some of the upside that the commodities markets are likely to see in the upcoming months.
Trades shared with the Masters in Trading community include buying long term options in copper, specifically Freeport Mcmoran, symbol $FCX. We also favor long term positions in silver miners like $PAAS. We also share Futures relative value futures trades with our community to take advantage of breakdowns in these longer term relationship trades.
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