Silver volatility exploded in recent days as a newly emboldened army of retail investors and traders targeted the commodity with their collaborative “momentum” approach.

The retail narrative driving GameStop (GME) higher last week was certainly riveting, but the fact is, momentum (aka “momo”) investing and trading has been around for many, many years.

To wit, the first-ever momo asset bubble is commonly attributed to a “tulip mania” roughly four centuries ago in the Netherlands. 

Even these days, only time will tell if Tesla (TSLA) ultimately ends up as a bubble as well. Either way, anyone jumping on the momo bandwagon needs to understand and accept the gargantuan risk associated with such plays.

One of the biggest risks associated with momentum trading is buying the top or selling the bottom. For example, GME is currently trading below $100/share, leaving investors and traders who paid more than $400/share for the stock deeply in the red.

In the investment industry, those who buy the top—or sell the bottom—are commonly referred to as “bagholders” (i.e. those left holding the bag). Bagholding is undoubtedly one of the biggest risks associated with so-called “collaborative investing.” 

For example, it’s certainly reasonable that a group of investors and traders might collectively agree that a stock or commodity is too cheap (i.e. “we like the stock!”), as was the case with GME. Through promotion on social media channels, a group of like-minded individuals can theoretically build considerable momentum to propagate their narrative. 

But once the stock/commodity/asset starts moving higher, that’s when things start getting complicated. 

How does the hive mind decide when that same stock/commodity/asset has gotten too expensive, or at least attractive enough to sell? It’s an especially difficult endeavor without coordination among group members, which is technically illegal. 

At some point, “lone wolves” are guaranteed to start taking profits, and in the process exchanging their profitable positions with emerging bagholders. 

That’s why momo plays aren’t about precisely picking the bottom or the top, but merely about entering at the ground floor and exiting before the crowd. Successful momentum traders are happy to take less profit and do so many times, as opposed to trying to pick a top in a single position. 

Picking direction successfully and consistently is extremely difficult, which is why many investors and traders instead choose to utilize mean-reverting strategies such as volatility-based options trading or trading pairs, as opposed to chasing the crowd. 

The current breakout in silver provides further context to the potential of the mean reversion trading philosophy. As many are aware, silver prices recently touched an eight-year high (over $30/ounce) and are currently trading about $26.97/ounce.

Since bottoming below $12/ounce last March, silver prices had already been on a tear, rallying over 133% during the final eight months of 2020. Silver closed last year trading $26.41/ounce before rallying to above $30 on the recent surge in retail trading. 

While the silver trade has since cooled off lately, investors and traders would be wise to monitor the Gold/Silver Ratio going forward.

The Gold/Silver Ratio is calculated by taking the price per ounce of gold and dividing it by the price per ounce of silver. The quotient of that equation reports how many ounces of silver are required to buy a single ounce of gold at any given point in time.

Currently, the Gold/Silver Ratio stands at roughly 68, which again is $gold/$silver ($1,842.20/$26.97 = ~68). That means approximately 68 ounces of silver are required to buy one ounce of gold. 

Over the last hundred years, the Gold/Silver Ratio has ranged between about 15 and 120. However, in the last 20 years, that range has narrowed slightly to between roughly 35 and 120. This means that at 67, the Gold/Silver Ratio is currently trading slightly below its recent historical mean.

It’s also well below the heights observed last summer, when the Gold/Silver Ratio rose well above 100. 

Traditionally, pairs traders sell gold and purchase silver when the Gold/Silver Ratio reaches the upper bounds of its historical range. Such a position theoretically benefits from a drop in the ratio—requiring gold to go lower, silver to move higher or a combination of the two. 

In 2020, that approach worked to perfection because after notching an all-time high during Q1 (above 120), the ratio proceeded to retrace back toward its mean during Q2 and Q3. 

As one can see in the above chart, the recent rally in silver is contributing to a further breakdown in the Gold/Silver Ratio—but this time in the opposite direction. 

If the current trend continues, and the Gold/Silver Ratio dips below 50, it’s likely precious metals traders will give another pairs trade in the sector serious consideration. In this case, however, it would be the reverse position as the one deployed when the Gold/Silver Ratio spiked above 100. 

To benefit from potential mean reversion in the ratio, traders would instead be deploying a pairs trade that performs well when the ratio rises—long gold and short silver. Such a position benefits if the Gold/Silver Ratio were to reverse course and rise back toward its mean (assuming it dropped to 50 or below). 

Unlike a naked position, a gold-silver pair theoretically provides better protection to an investor/trader because of the offsetting positions. Silver and gold have historically exhibited a long-term positive correlation of about 0.90, meaning the two typically move in lockstep.

The goal of the gold-silver pair, in this context, is to merely benefit from a reversion of the mean in the ratio, as opposed to a particular move in one metal or the other. But such positions are typically viewed as most attractive when the ratio is above 100 or below 50.

If the silver surge continues, one of those extremes could materialize at some point in H1 2021.

To learn more about the gold-silver pair, readers are encouraged to review a past installment of Market Mindset when timing allows. For an update on the current mania in the silver market, this new installment of Futures Measures is also recommended.

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Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to support@luckboxmagazine.com.