A Tale of Two Precious Metals – Gold/Silver Ratio
The investment community purchases gold and silver for different reasons. Typically they act
as a hedge or protection from concerns over inflation or times of economic instability and
uncertainty. They are valued in terms of the U.S. dollar, so periods of dollar weakness helps
to support their value. Recently, the lack of faith in paper and ink has put further pressure on
the U.S. dollar and has pushed gold and silver to new record highs. Also, a prudent investor
will expose their equity to a range of asset classes including precious metals i.e. gold and
silver as part of a diversified and balanced portfolio. Then there is the natural allure of silver
and especially gold, to have in one’s possession for comfort and in some cases pleasure.
Regardless of why an investor buys, holds or is thinking of purchasing gold or silver their
strategy is the same – “buy and hold”.
An old Wall Street saying, “Always keep ten percent of your portfolio in precious metals, and
hope that you’re wrong.”
For the more active investor, the essence of the gold-silver ratio is to switch holdings when
the ratio swings to the extreme historical levels. An example would be when an investor
holds one ounce of gold, and the ratio widens to say 100:1, the investor would sell their
ounce of gold for 100 ounces of silver. Conversely, if the ratio contracted or narrowed to say
32:1, the trader would sell their 100 ounces of silver for at least two ounces of gold. There is
no dollar value when making this trade; rather it is the relative value of the metals to each
other that is important.
The trading community, on the other hand, trades gold and silver for different reasons.
Typically, a trader would “take a view” on the price of either metal that it will move up or
down in price within a pre-determined and shorter (less than three months) time frame to
that of an investor. Simply put they want to profit from the near-term price activity and have
no desire to buy and hold. Their basis or reason to go long or short either metal can vary.
Both metals have cycles or seasonal patterns which is the tendency for a particular
commodity to behave (price wise) during a certain period every year. Gold has a seasonal
tendency to peak in late January after the holiday season, as jewellery demand starts to
decline. Price increases can last into the first part of February as dealers increase their
inventories for Valentine’s Day. Gold tends to post seasonal bottoms in late July or early
August. Silver has a tendency to make a major seasonal bottom in September and then has
a seasonal peak in April. Silver tracks the price of gold and is commonly referred to as the
poor man’s gold. The prices of both metals are subject to spikes in demand from the
investment community, which uses them as a hedge or protection. In general, both metals
move in the same price direction but sometimes at varying rates of change.
Rare Opportunity – Neither Bullish nor Bearish
The word “crisis” in Chinese is composed of two characters: the first, the symbol of danger;
the second, opportunity
This is where a spread trader seeks a trading opportunity, to profit from the price
discrepancy or variation in price between the two metals. The spread trader does not
necessarily need to be bullish or bearish either metal, rather the “spreader” will take a view
on whether their price relationship will widen or narrow. This price relationship is referred to
as the ratio between gold to silver. This ratio is a long-standing and classic trading
opportunity within trading circles. In late April of 2011, the ratio was around 32:1, that is gold
is 32 times the price of silver or how many ounces of silver it takes to purchase on ounce of
gold. I have no view or price target for either gold or silver, but I am a firm believer that
history repeats itself and for those who do not obey this, are likely to repeat the same
mistakes or miss a rare trading opportunity. In 1980, silver screamed up to extraordinary
highs of $50.36 and gold had its day in the sun reaching a high of $850.00, resulting in alltime highs for both metals. After the economic recovery in the early 1980s, gold and silver
settled to a much lower price for a lengthy period. If all things stabilize on the geopolitical
front, as they have in the past, and there is no major financial collapse or on-going crisis,
then one should consider employing a trading strategy. There is an appropriate saying that
speaks well to this opportunity,
“To know where you’re going you need to know where you’ve been”
During 1980, the gold/silver ratio was 30:1; in 1983 32:1, then in 1991 it was 100:1. In the
last 30 years the ratio for gold/silver has been as narrow (low) as 30 and as wide (high) as
100.
The Trading Strategy - Spot or Futures
In all cases, spread trading attempts to capture the price difference between two contracts
whereby one will outpace the other. As a spread trader we might have the view or speculate
that when gold and silver reach a ratio of around 32:1 the spread price is too narrow
(historically) and that we anticipate it should widen out to say 38:1. We look to sell silver the
“expensive” commodity (as it relates to gold) and buy gold the “cheap” commodity (as it
relates to silver). To benefit financially a trader can buy gold and sell silver in equal dollar
amounts, so long as the price/ratio widens out. Let’s take a close look at the spread history
of long gold and short silver during early May through to the end of June. This spread has
been profitable 87% of the time over the last 15 years, when you enter on May 8th and exit
the trade on June 30th. At the time of this report gold was $1500/oz and silver was $45/oz
(33:1). If you are interested in a rare trading opportunity that features capital preservation,
low costs, and prudent risk management using spreads, then consider these approaches.
Scenario #1 Spot market
By using a cash or spot position you can assign any dollar amount e.g. $30,000 to each leg
(one long, the other short) on whether the spread will widen or narrow. In this example, we
buy $30,000 USD gold (approximately 20 ounces) and sell $30,000 USD silver
(approximately 660 ounces) using a cash or spot metals dealer. There will be a holding cost
to “sell” or be short the silver and to “buy” or be long the gold. We anticipate that there is a 7
week holding period (to enter and exit the trade) with holding costs per day at 5% borrowing
means you will pay around $5.00 per day (not including commissions). As the individual
prices (of gold and silver) move up and down over time, you will notice that one will
inevitably outpace the other. The advantage here in this scenario is that you can choose the
dollar amount that is within your comfort zone. This is an OTC (over-the-counter) trade that
can be customized to your risk appetite and requires less than $5,000 in a trading/margin
account. See your cash/spot metals dealer for the precise costs for holding/borrowing and
commissions to purchase and exit this position.
Scenario #2 Futures market
Another approach used to trade this spread is by using futures contracts. In this case, we
would buy the full sized contract August Gold futures (100 oz) and sell Sep Silver futures
(5,000 oz) at the COMEX futures exchange and hold the spread for the same duration i.e.
early May through the end of June. Futures have no holding charges, but even with a
discounted spread margin of 50 – 70%, these futures contracts will require a margin of
$15,000 or more. If you are more comfortable with less than there are mini futures contracts
traded at the NYSE Liffe. The mini gold contract has 33 ounces and mini silver is 1,000. The
margin here will be at least half (under $10,000) to that of the full size contracts. In either
scenario, you will look for the price of gold to outpace the price of silver regardless of the
overall market direction. Consult with your futures dealer for a precise quote and the correct
contract ratio of silver to gold.
After a while you note that the ratio (gold to silver price) has moved from 33:1 to 37:1; both
markets have moved lower in price, for example gold is now $1400/oz and silver is $38/oz.
For demonstration purposes let’s assume we assigned $30,000 to each leg (using a spot
dealer). The $30,000 of gold bought at $1500/oz (20 oz) is sold at $1400 amounting to a
$2,000 loss; the $30,000 of silver sold at $45/oz (667 oz) can be purchased back at $38
amounting to a $4,500 profit. The net difference is (approximately) $4,500 - $2,000 = $2,500
profit. The silver outpaced the gold price. By this example you should be able to determine
how much equity to put towards this trade opportunity.
History Tends to Repeat
Seasonality suggests that a change in direction (gold/silver) to the upside (widens) occurs in
late April or early May. The two charts below represent the last 30 years for the gold/silver
spread. The monthly spread charts below tells us that the price of silver has outpaced the
price of gold regardless of the outright direction of either metal during this time frame. We
have seen that history itself offers an edge (with seasonal statistics) and can by itself be the
sole basis for your trading decision. As long as you determine your risk before you take on
the trade. You will need to establish your plan of action before undertaking this spread. You’ll
need to have your profit and your loss levels determined before you apply either (spot or
futures) trading approach. You will need to determine your risk to reward so that you remain
within your comfort zone. The monthly charts below range from 1980 till April 2011. Close
examination will show the seasonal tendencies for this spread to widen during the suggested
time frame of early May through the end of June. The seasonal strategy calendar indicates
that silver drops in value during mid-May through to mid-June around 64% of time over the
last 15 years. Perhaps this is further indication that silver might outpace gold.
Conclusion
As a trader of futures, we have to accept that any market can be erratic and unpredictable.
The outright gold and silver prices have been volatile with price spikes and over-extended
price ranges. By using a spread we greatly reduce much of this volatility and do not need a
profound view on the outright direction of either metal. In fact, we have created an entirely
new trading entity by spreading gold against silver and it has a life (trading opportunity) of
only 7 weeks in every year. Conversely, you might view the spread level 32:1 as a
benchmark or pivotal point. That is, if the spread moves below 32:1 then it will continue to
narrow. This idea is not advice or a recommendation. Rather it is awareness as to the
relationship of these two metals and a rare opportunity to profit. Here we offer an opportunity
to calculate, organize, review and present historical data that may inspire further thought,
analysis and create a tradeable viewpoint using a sound basis.