It’s quite easy for us to get carried away, especially when we’re trading stocks, cryptocurrency, or any other type of financial asset. When it comes to money, we have a propensity to let our greed get the best of us and make choices that aren’t in our best interests; I think this is due to the flawed nature of human beings. This is a piece about the collapse of a large hedge fund, as well as a discussion of why some people think the gold-to-silver ratio might not be reliable.
Long Term Capital Management (LTCM) was a financial technology company founded in 1994; it’s a hedge fund. Simply put, a hedge fund is a fund that manages money belonging to a small group of exceptionally wealthy and privileged individuals. Retail traders like you and I have no chance of investing in those funds, #NGMI. In contrast to ETFs, hedge funds are not subject to the same level of regulation, which means that they are free to pursue any course of action they see fit for profit. One of the largest hedge funds today is Citadel, and they have been accused of market manipulation. In brief, hedge funds are greedy mofo you cannot trust.
[Source: Reddit.com]
Anyway, because of the lack of regulation, LTCM used their money like a degen. The strategy they used was arbitrage, and they were doing it with huge leverage. During the 1997 Asian Financial Crisis, instead of investing in safety hedges, they continued to follow the model they developed, which embraces the principle of mean reversion. In case you were unaware, the gold-to-silver ratio trading strategy also includes the concept of mean reversion. The mean reversion strategy is straightforward, which believes that in the long run, the price of an asset will always return to its average level. Look at the chart below; notice how you could always buy low and sell high because the price always goes back to "normal" in the long run.
[Source: investopedia.com]
Gold-to-Silver Ratio
Fundamentally, the gold-to-silver ratio works based on this basic principle. If the gold-to-silver ratio goes up, you sell gold and buy silver. If the ratio goes down, you sell silver and buy gold. This is a perfect strategy with the presumption that the mean reversion will always work. LTCM believed in the mean reversion model they developed and took very high risk amid the financial crisis. In the end, they lost all their capital, and a group of 14 banks had to bail them out with $3.6 billion, which was a huge amount of money at that time.
Why did they fail?
The mean reversion strategy is flawed due to the fact that it does not take into account the unreasonable selling pressure that occurs during a financial crisis. Investors during that time were terrified, and panic sold everything and bought bonds which caused the mean reversion to diverge even more (LTCM were betting on bonds with their strategy.)
So, the moral of the story is mean reversion doesn’t work. Or is it? We must understand that the excessive use of leverage played a significant role in the failure of LTCM. They were too greedy and got “liquidated”. In my humble opinion, it would be safe to trade the gold-to-silver ratio with the mean reversion strategy as long as you don’t use leverage. By the way, there’s really no fiat money involved if you really think about it. If the gold-to-silver ratio goes up, you will have more silver. If the gold-to-silver ratio goes down, you will have more gold. How can you possibly get liquidated with this strategy?!
Conclusion
LTCM engaged in mean reversion trading with bonds while using a high level of leverage. The only scenario in which the gold-to-silver ratio means reversion trading strategy may fail is if the price of silver and gold decoupled into infinity. The fact that humans have always associated gold and silver together throughout human history, I am confident that they will not become decoupled forever. Or perhaps what could screw up the mean reversion is both gold and silver become dirt cheap for whatever reason, but if that’s the case, every strategy that long gold or silver will fail anyway.
(Any views expressed above are not financial advice)
If the ratio goes down enough I'll be sure to capitalize and trade some silver for gold
Though for some traders, they use the goldsilver ratio to trade but I just believe it does not really matters much
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