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With precious metals, good things come in pairs Add to ...

While there seems to be many opinions on the future prices of precious metals from many well-spoken prognosticators on both sides, it should be noted that a trading strategy exists that can help you capitalize on the relative price movements of any correlated investments. This is sometimes referred to as the "Pairs Trading Strategy."

Gold and silver would be a good example to demonstrate with, but we can use any two investments as long as they can be sold short. We know gold has been doing well lately, but silver has been on an absolute tear. Some might be inclined to believe that silver's ascent will cool off relative to gold. To capitalize on this, you could buy gold and short silver. Now, the only thing you care about is how well they do relative to each other.

If they both go down equally, you lose money on your long position (gold) and make money on your short position (silver). If they both go up equally, you make money on your gold position but lose money on your silver position. And if they are both flat then neither makes money. It should be noted, however, that you will lose slightly as you will be charged interest to maintain your short position.

Now, if they are both going down but silver goes down more than gold does, you're going to have a positive overall return: You make more money on the short than you lose on the long. Ditto if they both go up, but silver doesn't go up as much as gold: You lose less money on the short than you make on the long.

There are two main analyses used by pairs traders: 1) looking at historical trading ratios, and 2) looking at relative return prospects of the investments. If you believe that the two investments you are looking at have a historic price ratio, then when this ratio seems abnormally smaller or larger than usual, you would initiate a pairs trade. Alternatively, if you've identified two technology companies, for example, and believe that one will do better than the other regardless of the overall market direction, then you could initiate a pairs trade in this situation too.

As you can see, this trading strategy doesn't care about the overall market direction, which is why it falls under the category of being a "market-neutral strategy." So while you may not have strong convictions as to the short-term movement of precious metals in general, you may have stronger convictions about the relative price movements of individual precious metals. In that case, you may want to take a second look at pairs trading.

Preet Banerjee is the W Network's Money Expert and a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.


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