Lessons from a Red-Nosed Reindeer: The Power of Metals

“Silver and gold, silver and gold
Ev’ryone wishes for silver and gold
How do you measure its worth?
Just by the pleasure it gives here on earth

Silver and gold, silver and gold
Mean so much more when I see
Silver and gold decorations
On ev’ry Christmas tree” – Rudolph the Red-Nosed Reindeer

The classic Christmas movie provides the trader with some advice on portfolio diversification and asset allocation!

I love trading ETFs. I think it’s really great that we can make bets on the overall market through IWM or SPY, and place our opinion on what we think is going to happen with oil through USO, or a similar underlying.

A really interesting sector to trade is the metals, as referenced by Rudolph. We don’t really think about the price of gold and silver, because it doesn’t really effect our daily lives the way that the price of oil, or the overall market, does. Metal ETFs are sort of in a world of their own- they’re correlated to each other, but they tend to not be heavily correlated to other equities.

Gold especially moves inversely to the market. So, normally, when market goes down, gold goes up, and vice versa. People turn to gold as a relatively “safe asset” so it makes since that they flock to it in times of economic uncertainty (in other words, market downturns). Interestingly enough, volatility and gold are positively correlated, which makes perfect sense. People get nervous (uncertain), IV increases, they invest in gold (perceived to be safe), gold increases.

The entire metals market has this sort of relationship. So for investors that are long stock, and thus are bullish on the market, it might be a good strategy to invest in some metals, just to reduce overall market exposure and add some negative deltas to the portfolio. The key thing to remember here is we really don’t want to be overly biased on the market, one way or another.

And when we are only long stock, as many passive investors are, we are HEAVILY biased to up-moves. And that’s no fun when the market dips. It’s best to remain relatively delta-neutral, so a large move up or down won’t wipe you out.

(Quick note: positive deltas, which come an overall long portfolio, means that you are bullish on the market and want it to go up. Negative deltas, being short stock, means that you are bearish on the market and want it to go down.)

To get into the metals, and increase our negative deltas, we can trade XME, GDXJ, GLD, or SLV, just to name a few. GDXJ and XME are less expensive as compared to GLD and SLV. GDXJ is the junior gold miner’s ETF, XME is the metals and minings sector, GLD is gold, and SLV tracks silver.

Just for reference, XME experiences the most positive correlation to the market, at about 0.32 to the SP 500. So if the SP 500 goes up by 1 point, XME will increase by 0.32. So it might not be the best ETF to get some negative deltas in, BUT it’s still a good guy to trade to make a bet on the overall metals market.

GLD has the most negative correlation to the market (-0.33 to the SP 500) which makes it a good one to place against a positive delta portfolio. For every 1 point up move in the SP 500, we get about a 0.3 (or an entire third) of a point decrease in Gold. For comparison, SLV is about -10% correlation to the market.

Overall, we look to the metal stocks to reduce our overall portfolio volatility. One of my favorite trades is a short put vertical in GLD if I expect the market to decrease; a simply, yet effective way to place a bet on market movement without too much exposure. The metals are (relatively) uncorrelated to the rest of the market, which increases our diversification and reduces our overall risk, which is the trader’s dream! So listen to Rudolph and that lumberjack guy, and get into silver and gold!

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: