How to Trade the Gold Silver Ratio: Speculation and Security in the Modern Market

How to Trade the Gold Silver Ratio: Speculation and Security in the Modern Market
Page content

Hot Commodities!

Commodities speculation is booming these days and nowhere else can the rise in commodity prices be more marked than in precious metals. As of August 14, 2011, gold is trading at a historic high of over $1700 per ounce, whilst silver is creeping towards record prices at over $39 per ounce.

The gold silver ratio was first set by US law to be 15 to one. That figure is remarkably consistent with what geologists say is the true figure of the amount of silver in the ground as compared to gold. Silver is considered to be 15 or 16 times more abundant than gold.

Historically, the ratio was set by governments in an attempt to ensure monetary stability. In the age of the Roman Empire, for example, it was set at 12. Some quick arithmetic reveals that today’s prices are far removed from geological reality, as today’s ratio is 43.59 to one. This, however, is well within historical norms. As recently as 1991, the ratio was at 100, and it has hovered around that value many times in the past.

Is the Ratio a Useful Indicator?

Using the gold to silver ratio for daily trading will rarely come in useful. How to trade the gold silver ratio properly is to use it as a long term tool. Even as that, however, an investor would be foolish to base his entire strategy on a single yardstick. There are two basic plans of action for using the ratio. The first is to await a ratio expansion, and the other to await a contraction. If the ratio expands to extraordinary lengths, say to 100, then the metals trader could seize the opportunity to convert some of his gold holdings into silver. A drop in the ratio into the region of 20 or below, for example, would be an excellent chance to transfer some silver holdings into gold.

The trouble with using the ratio is, of course, whether the investor chooses the right moment to make the switch. If the investor decides to trade 200 ounces of gold for silver at 50 to 1, with the day’s price of $1700 for gold and $34 for silver, the investor will now have 10,000 ounces of silver. If the ratio continues to expand, however, then the investor loses the opportunity to convert the same 200 ounces of gold into 14,000 of silver in the event the ratio expands to 70. Basically, it’s highly important to an investor to choose the exact right time to convert.

Useful Ratio Strategies

There are several means available to investors that will teach them how to trade the gold silver ratio. Even without substantial funds, one can leverage certain financial instruments that will provide the investor with profits. The futures market is one such example, allowing an investor to purchase securities on margin. An even safer way to get involved would be through exchange traded funds, or ETFs. Of course, investing in either of the above two ways commits the investor to an ‘‘all or nothing’’ strategy, either your call pays off, or it doesn’t.

One popular strategy is to keep an open position on a futures trade or an ETF and keep adding to the position depending on where the ratio goes. If it rises, buy more silver positions. If it contracts, then switch to gold. This strategy protects the investor from taking what is essentially a wild guess on where the ratio is going to go, of course the trader pays for this safety margin with lower returns.

There have been hundreds of riskier strategies published, but of these the most consistent promises a kind of arbitrage_._ This involves the purchase of put options on gold and call options on silver when the ratio is high and the opposite when it’s low. The “bet” is that the spread will diminish with time in the high-ratio climate and increase in the low-ratio climate_._ Of course, the historically wider time spread usually required for significant changes in these two metal’s prices dictates that an investor interested in employing this strategy should use long-dated options, or leaps when taking out his positions.

Other Views and Tips

One interesting long term theory regarding the ratio is to disregard the price ratio and instead focus specifically on the market capitalization ratio. This is simply done by comparing the relative size of the value of the gold market with the value of the silver market. This ratio currently stands at over 200-1, and it indicates to some that silver is still very undervalued. An interesting case is made in favor of this argument.

Whichever strategy you as an investor feel comfortable with, remember that it is always safest to keep your overall holding of precious metals about equal in proportion over the long term. This will allow you to act when a major shift between the two occurs. Now that you understand how to trade the gold silver ratio, you can expand your knowledge into other facets of the concept.

For more tips and advice, be sure to check out Bright Hub’s Guide to Investing in Precious Metals.