Investors who begin to trade or follow the gold and silver markets aren't likely to go long without reading or hearing about the gold-silver ratio. The gold-silver ratio is an expression of the price relationship between gold and silver. The ratio shows the number of ounces of silver it takes to equal the value of one ounce of gold. For example, if the price of gold is $1,000 an ounce and the price of silver is $20 an ounce, then the gold-silver ratio is 50:1. As of July 2016, with gold trading at $1,322 an ounce and silver trading at $19.61 an ounce, the gold-silver ratio stood at 67:1.
According to fund manager Shayne McGuire, the gold-silver ratio is the oldest continuously tracked exchange rate in history. The primary reason the ratio is followed is because gold and silver prices have such a well-established correlation. Since 1968, the prices of gold and silver have moved in opposite directions only one time, for seven consecutive days.
The history of the gold-silver ratio
Historically, the gold-silver ratio has only evidenced substantial fluctuation since just before the beginning of the 20th century. For hundreds of years prior to that time, the ratio, often set by governments for purposes of monetary stability, was fairly steady, ranging between 12:1 and 15:1. The Roman Empire officially set the ratio at 12:1, and the U.S. government fixed the ratio at 15:1 with the Mint Act of 1792.
The discovery of massive amounts of silver in the Americas, combined with a number of successive government attempts to manipulate gold or silver prices, led to substantially greater volatility in the ratio throughout the 20th century. When President Roosevelt set the price of gold at $35 an ounce in 1934, the ratio began to climb to new, higher levels, peaking at 98:1 in 1939. Following the end of World War II, and the Breton Woods Agreement of 1944, which pegged foreign exchange rates to the price of gold, the ratio steadily declined, nearing the historical 15:1 level in the 1960s and again in the late 1970s after the abandonment of the gold standard. From there, the ratio rose rapidly through the 1980s, peaking at the 100:1 level in 1991 when silver prices declined to a low of less than $4 an ounce.
For the whole of the 20th century, the average gold-silver ratio was 47:1. In the 21st century, the ratio has ranged mainly between the levels of 50:1 and 70:1. The lowest level for the ratio was 32:1 in 2011.
There is wide disagreement among market analysts and traders regarding the current norm or expected average level for the gold-silver ratio. Some analysts point to the 20th century average ratio of 47:1, while others argue that a new, higher average ratio level has been established since the millennium. Other analysts continue to argue that the ratio should eventually return to much lower levels, around 17:1 to 20:1.
The importance of the gold-silver ratio for investors
The practice of trading the gold-silver ratio is common among investors in gold and silver. The most common method of trading the ratio is that of hedging a long position in one metal with a short position in the other. For example, if the ratio is at historically high levels and investors anticipate a decline in the ratio that would reflect a decline in the price of gold relative to the price of silver, investors should simultaneously buy silver while selling short an equivalent amount of gold, looking to realize a net profit from a relatively better price performance of silver compared to that of gold.
The advantage of such a strategy is that, as long as the gold-silver ratio moves in the direction an investor anticipates, then the strategy is profitable regardless of whether gold and silver prices generally are rising or falling.
Here is an example showing the outcome of such a trading strategy: From the beginning of 2009 to the beginning of 2011, the gold-silver ratio declined from 80:1 to around 45:1. During that period, the price of silver rose from around $11 an ounce to approximately $30 an ounce. The price of gold rose from approximately $850 an ounce to $1,400 an ounce. A 2009 buy of 80 ounces of silver against a short sell of one ounce of gold would have resulted in a profit of $1,520 in silver against a loss of $550 in gold, for a net profit of $970.