Which Is Headed Higher: Gold or Oil?

January 12, 2009

By Brad Zigler

Instead of being tossed over the transom, Friday's mail was slipped under the door: a single letter from Hard Assets Investor reader Bob.

Apparently, Bob's been watching the gold/oil ratio and hopes for a shorting opportunity after the next upward spike. In other words, he expects gold's price to ultimately weaken relative to crude.

Bob writes: "If the gold/oil ratio rises again, to say, 23-to-1 or higher, I'd bet gold's multiple would retreat toward its mean. How could I play this hunch using exchange-traded funds [ETFs]?"

The gold/oil ratio measures the value of gold in terms of how much oil it will buy. When Bob's letter arrived, an ounce of gold could buy about 21 barrels of crude. The ratio's long been used as a bellwether of economic health as well as a means to identify gold buying and selling opportunities.

No doubt, with the recent collapse of oil prices, the ratio's raced to levels not seen since the turn of the century (uh, that'd be the turn into the 21st century). Over the past three decades, the ratio's found support at a gold multiple of eight or 10 barrels. Occasionally, excursions above 20, or even 30, barrels have been made, but these levels seldom hold for any length of time. In fact, the mean level for the ratio over the past two years charted below is 9.7-to-1.

Gold/Oil Ratio

Back in November, as the ratio was rising, we looked at buying the ratio ("Trading the Gold/Oil Ratio With ETNs"). We paired long positions in the PowerShares DB Double Long Gold ETN (NYSE Arca: DGP) and the PowerShares DB Double Short Oil ETN (NYSE Arca: DTO) and, after a month, the ratio peaked at 24.8-to-1. The volatility-adjusted ETN pairing gained an aggregate 18.8% as a result.

For ratio bears like you, Bob, a reverse position can be established by purchasing the mirror-image notes, namely the PowerShares DB Double Short Gold ETN (NYSE Arca: DZZ) and the PowerShares DB Double Long Oil ETN (NYSE Arca: DXO). To make the trade track the ratio effectively, though, you'll need to balance the combination for the respective ETNs' price and volatility.

At last look, the DZZ note was worth $26.26 and DXO was priced at $2.98. Let's call those Price 1 (P1) and Price 2 (P2), respectively. Balancing the dollars at risk in each position means you should buy nine DXO notes for every DZZ purchased (P1 ÷ P2 = 8.8, but we'll round it to 9).

Since the notes' volatilities, or daily price variances, differ, you'll need another adjustment. Using the techniques laid out in the November column, you'd see DXO's volatility was a whopping 132.2%. DZZ's comes in at 74.6%. Without compensating for DXO's higher volatility, your combination's value would skew in short order.

If we make DZZ Volatility 1 (V1) and assign Volatility 2 (V2) to DXO, we can write the total adjustment factor as:

V1P1 ÷ V2P2 = (26.26 x .746) ÷ (2.98 x 1.322) = 6.2

So, if you buy six DZZ notes for each DXO, you're good to go, Bob

Oh, by the way ...

I know you asked about exchange-traded funds, not notes. There are more short and levered products on the note side, though. You also rid yourself of index tracking error with ETNs. The trade-off is the exposure to credit risk. You've got to feel comfortable about the continued solvency of the ETN issuer which, in the case of the notes described above, is Deutsche Bank's London branch.

To buy Hallmarked 999.9 Pure Swiss Gold Bars, Gold Bullion, Gold Ingots & 916 Gold Coins in Singapore or convert your 916 Physical Gold to physical 999.9 Pure Swiss Gold Bars, Click on Buy Gold to find out more. You may Sell Gold to us too.

[ Back To Home ]