On 21 November, I posted a blog outlining some thoughts on the possibility of platinum outperforming gold.
The entry strategy discussed was triggered in late January. In recent days platinum broke above resistance and last night, jumped sharply. I thought now might be the time for a follow up discussing approaches to stop loss management and profit objectives.
The current positition
Platinum fell to a low relative to gold in October last year. At that time, an ounce of platinum bought just 0.86 oz. of gold.
This compared to the peak in 2008 when you could buy 2.36 ounces of gold with an ounce of platinum.
As the ratio chart below shows, platinum's decline relative to gold began to lose momentum last year, forming a descending triangle pattern.
The ratio broke out of this pattern early in the New Year and, a couple of weeks later, pushed through resistance dating back to the 2008 lows.
By 24 January the ratio pushed above 1.005 (1 ounce platinum buys 1.005 ounces gold). This was the entry trigger discussed in the November post.
At the close of trade yesterday, the ratio had risen to 1.037.
The catalyst for platinum's outperformance was confirmation by the world's largest miner, Anglo Platinum, that it will reduce annual production by 400,000 oz as part of a cost saving initiative. This together with the threat of industrial unrest in South African mines and the improving outlook for industrial and motor vehicle demand has boosted platinum prices.
To read the original post and strategy Click Here
Of course, one alternative for this circumstance would simply be to buy platinum. The pairs trade is a precious metals neutral alternative. It will work if platinum does better than gold and lose if it underperforms. For example, if precious metals decline overall, the pairs trade will profit if gold falls by more than platinum.
In the ratio chart, the 200 day moving average, and triangle resistance now provide support at around the same level. A move below this would be a sign of weakness. So one approach would be to place the stop loss behind this level rather than under the extreme low at .86 as discussed in my earlier post. Using this approach the stop loss would be set at a ratio of around 0.92.
Looking at this chart, it seems hard to ignore the possibility that this ratio could make a decent partial retracement of the whole decline from 2.36. This would simply get it back to levels consistent with a better economic environment such as we saw leading up to 2007.
The strategy shown on the chart takes a more conservative approach to begin with, setting an initial target at the 50% retracement level of the last major leg lower since 2010. If this is reached, one approach would be to either sell half the position or simply move the stop higher to protect existing profits.
The stop could also be moved up behind any major new support levels that might develop in future
A standard approach to pairs trading is to adopt a value neutral approach to trade entry. For example a trader may buy $50,000 of platinum and sell $50,000 of gold. At current prices displayed on the order tickets below this would involve buying 30.23 oz platinum and selling 30.808 oz of gold
As this position involves a ratio, between 2 prices, many traders would not leave set stop loss and take profit orders on the individual positions in the market. Set orders run the risk of being taken out of one leg and not the other.
Because this is a big picture trade, another approach is to run the risk of some intraday slippage. The trader simply checks the position daily e.g. in the morning Australian time. If the ratio between the 2 trades falls below the trader's stop level (e.g. 0.92) then orders are placed to sell platinum and buy gold. Thinking positively, the same is done if the ratio reaches profit objectives.