When you first start to trade, it’s best to stick to just a small number of stocks.
You might even start with just one. That’s what I did.
As a floor trader at the Chicago Board Options Exchange during the 1980s, I spent years trading one, two – and eventually just a handful of stocks or indices, over and over again.
Even to this day, the S&P 500 index is my go-to market to trade.
By focusing on just a few stocks or indices, you quickly learn how they react to any news event. Before long, you’ll know them like the back of your hand.
Knowing everything about a stock or index is key. However, there are other things I use to put the odds in my favor.
One of those is gauging how markets move in relation to each other. And then learning how to profit from it. This relationship is called correlation. It’s a key part of my trading strategy.
Now, there are many examples of correlations in the market.
Like the S&P 500 index against the oil price. Or, Bitcoin versus gold.
Markets all move in relation to each other. Sometimes in tandem, other times in opposite directions. By watching one market, it can help you predict what another market might do.
One correlation that precious metal traders have watched for a long time is that between gold and silver.
The chart below plots the ratio of gold against silver over the last 30 years.
Gold / Silver Ratio
Source: macrotrends
The jagged blue line in the chart measures the multiple at which gold trades to silver, per ounce.
Meaning, that if silver is trading at $20 an ounce, and the gold silver ratio is 80, then gold will be trading at $1,600 per ounce (80 x $20 = $1,600).
The upper red horizontal line in the chart indicates where gold trades at 80 times the value of silver. The bottom red line shows where this ratio is around 45.
You can see that for most of the last 30 years, gold has traded between 45 and 80 times the price of silver.
You can use this correlation as a guide for many types of trades.
For example, if both gold and silver are trending higher – along with the gold / silver ratio – I would likely buy gold over silver.
That’s because if the trends hold, gold will rally more strongly than silver.
If the opposite occurred – all three trending lower – I would look to short gold instead of silver.
In this scenario, gold would likely fall quicker than silver. And so on.
You can use correlations like this as a guide for when to place gold and silver trades.
Importantly, correlations exist across all types of markets – in stocks, commodities, indices, and bonds. From one market and sector to another.
To be clear, it doesn’t mean you have to trade all these other markets.
As I mentioned at the top, I encourage you to pick just one or two stocks or indices and stick with them.
However, it’s beneficial to watch other markets that you’re not familiar with. Then, pay attention to how they correlate to the market you’re trading. Once you get a feel for how they move, you can add them to your trading arsenal.
Bottom line: By understanding correlations – along with trends and mean reversion – there’s no doubt it will give you a big edge as a trader.
Regards,
Larry Benedict
Editor, Trading with Larry Benedict
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