A Novel Approach to Trade Gold: Pair Trading Gold Versus Gold Miners
Gold has long been regarded as a cornerstone of a well-diversified portfolio. It’s a hard asset with a fixed supply, making it attractive in times of inflation, economic shocks, and geopolitical turmoil. However, while gold has such benefits, it does come with episodes of high volatility and outsized drawdowns.
Enter the Gold Market Neutral Strategy—a market neutral approach that generates superior risk-adjusted returns and is uncorrelated to both gold and the gold miner’s index. Let’s dive into how this strategy works.
The Strategy: Pair Trading Gold and Mining Stocks
The cornerstone of this strategy lies in the relationship between gold (tracked by ETFs like GLD) and gold mining stocks (tracked by ETFs like GDX). These assets share a strong correlation (around 0.76), making them ideal for pair trading.
The Core Idea:
Bet on Convergence: if the spread between gold and the miners’ index widens, anticipate a return to equilibrium. Below graphs show the behavior of the spread, plotted as the price ratio GLD/GDX where we can observe a mean-reversion characteristic:
The Trading Rule
We transform the ratio time series into an oscillator. To do this we calculate a statistic called the ‘Z-Score’. It is defined by the following formula:
From the above chart we see that the Z-Score acts like an oscillator centered at the zero line. The strategy goes short the pair (short gold/long mining stocks) when Z-Score is stretched to the positive side and goes long the pair (long gold/short mining stocks) when the Z-Score is stretched to the negative side.
Position Sizing
Gold and the gold mining index exhibit distinct volatility profiles. Over the long term gold’s volatility is about 17% while the gold miner’s index is about 41%. Because we are doing pair trading, we want to adjust position sizes to normalize for volatility. We use the following equation to do this:
And this is the graph of exposures over time:
The Backtest
In this backtest we make the following assumptions:
- The calculations are performed daily prior to the close and we trade at the close
- We use 2X leveraged ETFs
- The uninvested balance goes to a daily interest earning sweep
We observe the strategy’s performance stability when compared against gold and the mining index. We also note that the strategy has invested exposure only 12% of the time. The other 88% of the time it is in cash which can be shifted to an interest earning instrument or invested in another trading strategy.
Implementation
This is a short term strategy and it requires the calculation and the trades to be made near the session close.
And because this is a hedged strategy, it uses 2X leveraged ETFs to boost performance. The following 2X ETFs are available:
- Gold: UGL/GLL
- Miners: NUGT/DUST
For greater capital efficiency & higher returns, the strategy can also be implemented with futures. One can use gold futures (GC) versus 2X leveraged gold mining ETF.
Another way to achieve significantly higher performance is through options: calls & puts on GLD and GDX ETFs. One would need to focus on longer dated contracts with at-the-money strikes to minimize theta decay.
Conclusion
Gold is a good long term portfolio exposure to have but a volatile asset to hold long term. The Gold Market Neutral Strategy provides long/short exposure with higher returns and a fraction of the volatility.
The strategy is in the market only 12% of the time – this low exposure makes it a good candidate to combine with other strategies that also have low temporal exposure (time in market). Combining multiple short term strategies that are infrequently in the market can lead to very interesting results in terms of return and Sharpe ratio.
