There are two basic means by which one can speculate in the markets. You can bet on prices, or what's known on Wall Street as directional or "outright" trading. Or you can bet on the relationship between prices. In stocks, this kind of wagering is called a "pairs trade." With commodities, a trading spread.
Spread trading involves a different mentality than more traditional speculation, most notably because it involves two separate trades. By taking a long position in one security and a short position in another, spread traders are anticipating the price of two historically connected entities will change -- usually that they'll revert back to historical norms.
Such an opportunity might again be present in precious metals, where the price of gold now exceeds that of platinum by the widest margin in more than 27 years, despite platinum's comparative scarcity. More than ten times more gold is mined each year than platinum, and it's often noted that all the platinum ever mined throughout history would fit into the average American living room.
During economic expansion, platinum prices tend to outpace gold given its dual role as both a precious and industrial metal. But when the economy wanes, platinum can often stumble. During the 2008 financial collapse, platinum prices fell from $2,252 to $774, a drop of nearly 65%.
Back then we described a means by which to trade the spread using popular exchange-traded products. By combing a long position in a platinum-linked exchange-traded fund like iPath DJ-UBS Platinum ETN (PGM)
While theoretically less exposed to outright directional movements in the price of a security, spreads can often remain out of whack for extended periods of time. For example, platinum dropped below the price of gold back in the early 1980s, pushing the spread below 1.0 for the better part of 5 years as the economy slowly recovered.
But with the exception of a brief drop during the early 1990s recession, the spread has almost always remained positive -- until now. Therein lies the trade.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC