Escape the Volatility: How Spread Trades in Gold and Mining Stocks Work

Minyanville

As volatility finally starts to reappear, the risk of overtrading and being shaken out of positions increases. Words like "abnormal" and "new normal" continue to be used in an attempt to capture the frayed and strained markets that we trade. Stretches in equity prices to nosebleed levels, the use of safety stocks as a substitute interest-bearing account, and the continued piling into bonds despite the fact that they literally pay nothing and carry huge downside risks have all become commonplace in this upside down environment.

If you want to view the extreme extremes, just take a glance at Japan the past couple days where bond yields have risen from nothing to 1% in a heartbeat, the yen has plunged to depths unimaginable in just a few months, and the stock market has gained upwards of 60% to 70%, depending on what you are using to do the measuring. Yes, these are abnormal times.

One way to escape the volatility is through spread trades where you control both a long and short position based on a relationship that itself is strained. One such strained relationship is that of gold mining equities to the price of gold. When gold prices are set to rise, the strongest gold miners tend to outperform; when they decline, they underperform. Here's a chart of such a relationship using Randgold Resources (GOLD) and the SPDR Gold Trust ETF (NYSEARCAGLD). Notice how, in almost all cases over this five-year period, the aforementioned relationship has held and that right now, the premium in Randgold is minimal compared to that of the physical.

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Charts from investools.com

Note also how the relationship is almost always positive for Randgold, which happens to be one of the lowest cost producers out there.

If you believe that gold is or will be making a bottom anytime soon, then one way to supercharge your returns is to buy Randgold instead of the gold itself. A much safer way to trade gold, though, is to trade the relationship between these two instruments with a spread trade, legging into a short position on the gold ETF when the price of gold rises, and into a long position on Randgold when the price of gold drops and drags it lower. In this way, you can use the volatility and this relationship to your advantage, slowly building a nice profit without all the risk that one-sided trades carry with them currently.

[More from Minyanville.com: The Important Breakout in the Dow to Gold Ratio and Its Implications for Gold ]

If and when gold does find a bottom and begins to rise, you will be handsomely rewarded. In the meantime, you can create gains off of volatility by using anchored support and resistance on the GOLD and GLD charts to time your entries and exits.

Twitter: @tatoday

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