Gold vs. gold-miners: another arbitrage opportunity?

  • November 8, 2006
  • Ernest Chan, Ph.D.

Recently, there has been mounting interest in buying gold (for
example, see this

report at TheStreet.com). I am not much of a fundamental analyst, so I won’t
go into the economic reasons whether to own or not own gold now. Rather, I would
like to see if there is an arbitrage opportunity here in the midst of all this
excitement.

I talked about before why I believe energy futures and energy companies ETF are
“cointegrated”, i.e. when their spread wanders far from a mean value, there is a
high probability that they will revert to the mean. The same analysis can be
made about other pairs of commodity futures and ETFs. Therefore I apply this to
gold.

Looking around for ETFs that hold gold miners, I found
(
GDX |
Quote |
Chart |
News |
PowerRating). It started
trading on May 23, 2006 and therefore has a relatively short history for us to
analyze. We could have paired it against the front-month gold futures contract
GC, but this may be inconvenient because one has to rollover the contracts
monthly. So instead, we pair it against an ETF that holds gold as a commodity.
(
GLD |
Quote |
Chart |
News |
PowerRating)
is one such example. (So is IAU, but GLD is far more liquid.) Using the same
Matlab cointegration package that I mentioned in the previous article, I
determine that even with the short history, GLD cointegrates with GDX with a 90%
probability. Also, the package tells us the proper combination is 60 shares of
GLD vs. 100 shares of GDX. So if we form a pair by buying 60 shares of GLD and
shorting 100 shares of GDX, we can plot the value over time here:

There were indeed numerous instances of reversion to the mean. I was able to
take advantage of the high around mid-July and shorted this spread profitably,
and I also bought the spread around the low in early September and exited my
positions profitably around mid-September. As of the 1st of November, the spread
is once again in sufficiently negative territory to warrant attention.

There are some caveats with trading this spread. First, it is not always easy to
borrow GDX or GLD to short. It depends on if your broker has a good securities
lending desk. Secondly, the history of GDX is short. So any analysis must be
taken with a grain of salt. To overcome this short history, I could have
constructed my own basket of gold mining stocks and plot the price of this
basket against the gold futures GC. If you intend to invest heavily into this
spread, I would definitely recommend doing this piece of hard work.


Ernest Chan, Ph.D. is a quantitative trader and consultant who helps his clients
implement automated, statistical trading strategies. He can be reached through
www.epchan.com. Ernie has worked as a
quantitative researcher and trader in various investment banks (Morgan Stanley,
Credit Suisse First Boston, Maple Securities) and hedge funds (Mapleridge
Capital, Millennium Partners, MANE Fund Management) since 1996. He has a Ph.D.
in physics from Cornell University.