For the hard-asset enthusiast, the gold-silver ratio is common parlance. For the average investor, it represents an arcane metric that is anything but well-known. The fact is that there is substantial profit potential in some .established strategies that rely on this ratio.
The gold-silver ratio represents the number of ounces of silver it takes to buy a single ounce of gold. Here's how investors benefit from this ratio.
How the Ratio Works
When gold trades at $500 per ounce and silver at $5, traders refer to a gold-silver ratio of 100. Today the ratio floats because gold and silver are valued daily by market forces, but this has not always been the case. The ratio has been permanently set at different times in history - and in different places - by governments seeking monetary stability.
Here's a thumbnail overview of that history:
- 2007 – For the year, the gold-silver ratio averaged 51.
- 1991 – When silver hit record lows, the ratio peaked at 100.
- 1980 – At the time of the last great surge in gold and silver, the ratio stood at 17.
- End of the 19th Century – The nearly universal, fixed ratio of 15 came to a close with the end of the bi-metallic era.
- Roman Empire – The ratio was set at 12.
- 323 BC – The ratio stood at 12.5 upon the death of Alexander the Great.
These days, gold and silver trade more or less in sync, but there are periods when the ratio drops or rises to levels that could be considered statistically "extreme." These extreme levels create trading opportunities.
How to Trade the Gold-silver Ratio
First, trading the gold-silver ratio is an activity primarily undertaken by hard-asset enthusiasts often called "gold bugs." Why? Because the trade is predicated on accumulating greater quantities of metal and not on increasing dollar-value profits. Sound confusing? Let's look at an example.
The essence of trading the gold-silver ratio is to switch holdings when the ratio swings to historically determined extremes. So,
- When a trader possesses one ounce of gold and the ratio rises to an unprecedented 100, the trader would sell their single gold ounce for 100 ounces of silver.
- When the ratio then contracted to an opposite historical extreme of 50, for example, the trader would then sell his or her 100 ounces for two ounces of gold.
- In this manner, the trader would continue to accumulate quantities of metal seeking extreme ratio numbers to trade and maximize holdings.
Note that no dollar value is considered when making the trade; the relative value of the metal is considered unimportant.
For those worried about devaluation, deflation, currency replacement - and even war - the strategy makes sense. Precious metals have a proven record of maintaining their value in the face of any contingency that might threaten the worth of a nation's fiat currency.
Drawbacks of the Trade
The difficulty with the trade is correctly identifying the extreme relative valuations between the metals. If the ratio hits 100 and an investor sells gold for silver, then the ratio continues to expand, hovering for the next five years between 120 and 150. The investor is stuck. A new trading precedent has apparently been set, and to trade back into gold during that period would mean a contraction in the investor's metal holdings.
In this case, the investor could continue to add to their silver holdings and wait for a contraction in the ratio, but nothing is certain. This is the essential risk for those trading the ratio. This example emphasizes the need to successfully monitor ratio changes over the short and medium term to catch the more likely extremes as they emerge.
Gold-Silver Ratio Trading Alternatives
There are a number of ways to execute a gold-silver ratio trading strategy, each of which has its own risks and rewards.
- Futures Investing. This involves the simple purchase of either gold or silver contracts at each trading juncture. The advantages and disadvantages of this strategy are the same: leverage. That is, futures trading is a risky proposition for those who are uninitiated. An investor can play futures on margin, but that margin can also bankrupt the investor.
- Exchange-Traded Funds (ETFs). ETFs offer a simpler means of trading the gold-silver ratio. Again, the simple purchase of the appropriate ETF (gold or silver) at trading turns will suffice to execute the strategy.
Some investors prefer not to commit to an "all or nothing" gold-silver trade, keeping open positions in both ETFs and adding to them proportionally. As the ratio rises, they buy silver. As it falls, they buy gold. This keeps the investor from having to speculate on whether extreme ratio levels have actually been reached.
- Options Strategies. Options strategies abound for the interested investor, but the most interesting involves a sort of arbitrage. This requires the purchase of puts on gold and calls on silver when the ratio is high and the opposite when the ratio is low. The bet is that the spread will diminish with time in the high-ratio climate and increase in the low-ratio climate. A similar strategy can be applied to futures contracts also. Options permit the investor to put up less cash and still enjoy the benefits of leverage.
The risk here is that the time component of the option may erode any real gains made on the trade. Therefore, it is best to use long-dated options or LEAPS to offset this risk. (For more insight, read Option Spread Strategies.)
- Pool Accounts. Pools are large, private holdings of metals that are sold in a variety of denominations to investors. The same strategies employed in ETF investing can be applied here. The advantage of pool accounts is that the actual metal can be attained whenever the investor desires. This is not the case with metal ETFs where certain very large minimums must be held in order to take physical delivery.
- Gold and Silver Bullion and Coins. It is not recommended that this trade be executed with physical gold for a number of reasons ranging from liquidity to convenience to security. Just don't do it.
There's an entire world of investing permutations available to the gold-silver ratio trader. What's most important is that the investor knows their own trading personality and risk profile. For the hard-asset investor concerned with the ongoing value of their nation's fiat currency, the gold-silver ratio trade offers the security of knowing, at the very least, that they always possess the metal.