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Commodity ETFs

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Many of you know from my last article that I warned that a major sell off in Silver and Gold could occur due to the recent strength in the U.S. Dollar coupled with the deteriorating economic fundamentals in Europe.

What I did not know was that there was another selling pressure on Gold and Silver Prices, and that was the mass liquidation by hedge funds selling their winning precious metals positions to pay for the margin calls they were having on their losing equity positions. All of the above created a huge sell off, pushing gold and silver prices down by more than 15% from their recent peak.

With Gold and Silver and their corresponding ETFS GLD and SLV down so sharply, is it now time to step up and buy these ETFs on a dip? Or is the trend over and it's now time to sell these precious metals short through their inverse ETF's,Proshares UltraShort Silver (ZSL)- the 2x leveraged inverse Silver ETF, which profits when Silver falls or the inverse Gold ETF, Proshares Ultra Short Gold (GLL)- which is the 2x leveraged inverse Gold ETF, that again only profits if Gold prices fall.

The easiest answer is I don't know? because the market is not signaling an obvious direction, and therefore the safest way to invest is to hedge by using a simple paired trading strategy. A paired trading strategy is when you simultaneously sell equal dollar amounts of two highly correlated (meaning their prices move in tandam together in the same direction almost all the time) investment vehicles.

Since Gold and Silver are highly correlated most of the time, when they go out of correlation there is profit to be made.This usually occurs when there is a major market move up or down, where one metal declines a lot more than the other, or vice versa one metal gains a lot more than the other.

This is precisely what has happend during the last two months. Silver prices have fallen almost double the amount gold has. Silver prices have fallen from a internmediate high of $44 to $30, an almost 32% decline, while Gold Prices have fallen only 17% from their intermediate peak to its current price of $1650.

Therefore since Silver has decline by so much more than Gold recently two scenarios should occur, the first is that both precious metals rebound and Silver rebound almost twice as much as gold, or the second scenario is that there has been a change in fundamentals and precious metals prices continue to fall, in that case Gold should fall almost double the amout that Silver does.  The reason for this is the price movement of Gold and and the price movement of Silver usually remains static. When it gets way out of wack, as it is right now with Silver down almost twice as much as gold, the price relationship of both metals will revert back to the mean, meaning that one metal will move sharply more than the other until equilibrium between the prices is met.

The most basic way to play this mean reversion trade execute is to buy the iShares Silver Trust ETF, (SLV - ETF report) and short the Ishares Gold ETF (GLD - ETF report), in equal dollar amounts. But many investors dont like shorting or are not allowed to short in their accounts, so another method is to buy ProShares UltraShort Gold ETF  (GLL - ETF report), which will fall twice as much as Gold prices do, and at the same time buy the Proshares Ultra Silver (AGQ) which will move 2X the amount that actual Silver prices move.

In summary, with no obvious signal as where precious metals are heading, the best way to invest in this sector is to hedge, and the smartest hedge right now is Long Silver and Short Gold.

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