As anyone who’s winced at the rising cost of filling up their tank will know, commodity prices have running hot recently. May brought some relief with Oil dropping back below $100 and precious metals losing some of their shine. While gold has been hitting the headlines for some time, this precious metal hasn’t been the top commodity for traders in 2011. Not even close!
Gold has indeed by hitting new record highs in 2011, but it has been outshone by that other precious metal – Silver.
The monthly chart of the two precious metals below shows how both alloys have been rallying fairly steadily since 2002 with gold the clear winner until mid 2010.
However in the last 12 months it is Silver that has been on the biggest bull run, with an acceleration of momentum that makes even gold’s record breaking run look pedestrian.
The price of Silver more than doubled in just 6 months, hitting an all time high of $50 recently. So what gives?
The short answer is speculation. With gold rallying strongly, traders started to look for other assets that might follow in its tailwind. This will have been a natural process to begin with as the two metals are highly correlated. One catalyst for the rally in gold and silver is the ready availability of new vehicles to trade it with. Previously the only vehicles available to speculators were purchasing forward futures contracts, or spread betting in the UK (though the latter is of little interest to giant hedge funds). However, in recent years we have seen an explosion in the popularity of ETFs (Exchange Traded Funds) as means to buy commodities like silver. This means you can buy silver as easily as you might buy an individual share or investment fund.
There is one big difference between gold and silver; size & liquidity. The number of contracts available and shares floated for gold ETFs is far greater than that available for the equivalent Silver vehicles. So as interest built in Silver, the rally became self-fulfilling as demand continued to out strip supply.
Fortunes were made in this mini bubble with hedge funds boasting of gains of 50% year to date in 2011 thanks to leveraged positions in commodities like Silver.
That was until the commodity prices reversed spectacularly in May, with Silver showing all the classic symptoms of a bubble bursting.
Hedge fund investors impressed by the huge trading gains year to date were served a timely reminder of the old stock market adage of never confusing genius with a bull market.
Silver rallied 86% in four months, but recently dropped 21% in just four days. The speed of the collapse caused more damage than the size.
Even accounting for the recent drop though, there is no denying that Silver would have been a good investment over the last few years. However, as we know with the stock market, any gains from buy and hold investments can quickly disappear, especially when the market in question has the ability to drop 21% in just four days.
The chart below shows how a £1,000 investment would have performed in Silver going back to 2006. Without compounding, £1000 would now be around £2250, but with compounding it would be around £2500. There was a nasty period of draw down though with a peak to trough slip of -57%.
This is where trading strategies can help increase returns by helping you to capture large portions of gains from a bull market while avoiding sizeable losses when the party is over. Any trading system should be able to beat the returns from investing in silver or match them with a significantly lower risk profile – or both!
Silver prices are available to spread bet with most firms including IG index. You can get live prices on Meta Trader through What Really Profits recommend Broker Smart Live Markets.
How to trade Silver
Stock markets respond very strongly to ‘mean reversion’ strategies which make use of tools such as the DVB indicator as introduced in the previous article. The DVB oscillates between 0 and 100 with 50 often used as a key mid point. On stock markets, the basic strategy has been to buy into weakness (readings below 50) and sell into strength (readings above 50).
When applying the same strategy to Silver, it is evident that we are dealing with a very different market. In fact, applying the basic rules above fails so consistently that doing the exact opposite can be a very profitable strategy.
Silver, like many commodities and forex pairs is not mean reverting in the same way that stock markets are. While stock markets are likely to reverse after a strong up day, markets like Silver are more likely to follow through on this strength.
The rules are therefore relatively simple:
Attach the DVB indicator to your charts – you can see how to do this here
Buy on readings above 50. Sell on readings below 50. Let’s apply this to some charts:
The chart below is on Silver Daily time frame with the DVB (AKA DV2) indicator displayed on the bottom panel.
We can see a successful trade with the DVB crossing above 50 in late January, triggering a long trade at 27.58. The DVB didn’t cross below 50 until the end of February, causing the trade to exit at 32.09 for a return of around 4.50 points, or £450 if trading at £100 per point.
It’s not always this smooth by any means as the signal was to go short immediately after this, resulting in a losing trade as the pullback proved short lived. Going short in any bull market is fraught with difficulty, however you have to take such small losses because you always have the possibility of being on the right side of a big reversal as we saw in late April.
Here the short signal was absolutely spot on, allowing you to latch on to the big reversal. The DVB slipped below 50 at 47.89 and stayed below there until the marker recovered with the trade reversing to the long side at 37.73 for a total return of 10.16 points, or £1001.60 if trading at £100 per point.
The DVB has since been flipping above and below 50, causing some of the gains to be given back, but this simple strategy certainly would have helped to get you on the right side of the move.
This system does very well considering how simple the inputs are.
A £1,000 starting amount would now be worth just under £3,000 without compounding, rising to over £5,000 with compounding.
The strike rate is 49% with the average winner being 1.55 times the size of the average loser. The strategy increases returns on simply buying and holding silver by some margin but there have still been some jolts along the way, the worst draw down of – 46% is superior to the draw down seen with buy and holding silver, but can we better it without hurting returns too much?
Beware of volatility
One thing to note is that markets have a tendency to become more mean-reverting following a big shock. Think of the system being good as akin to surfing; if the waves become the size of a tsunami, anything is going to struggle. We want trend following conditions when trading silver, so obviously it makes sense to avoid conditions that we know are associated with mean reversion.
One filter I have applied is to pull out of the market entirely when the standard deviation is at the highest it’s been the last year.
This drops the total return slightly for simple returns, but boosts it for compound returns because it massively decreases volatility. The worst draw down now becomes -21%.
The bottom line
Simply buying silver on leverage had been a successful strategy until May 2011, but as the legion of hedge funds now licking their wounds from over leveraged losses will tell you, commodities don’t just go in one direction forever.
What this DVB led trading strategy does is to give you the flexibility to capture a big part of the trend on the upside while switching to go against the trend only when conditions are right.
As good as this strategy is, I would see it as a very powerful addition to a panel of indicators available to you when trading markets such as Silver. The following article on using the Yawn indicator to spot over bought conditions shows how using multiple inputs could help improve your returns further.