EDITOR'S NOTE: For those of you who were following us in 2020, you’ll remember the gold-silver ratio’s astounding 5000-year high. It was the trading opportunity of a lifetime (plus five millennia) for those who were prepared to take advantage of the blatant imbalance between the prices of the two metals. Yet, many people missed it. Why? Because many investors didn’t understand how the gold-to-silver ratio works. They don’t understand the context surrounding this valuable indicator. And that prevents most from anticipating, let alone trading, actionable scenarios. Well, here’s a quick tutorial. The good thing is that you don’t have to wait another 5,000 years. The ratio fluctuates often enough. And right now, the gold-to-silver ratio appears to be approaching another relative high. So, if you’re looking to trade, add to, or rebalance your gold and silver holdings, it’s almost imperative that you understand what this ratio is telling you, lest you risk missing out on another golden market opportunity.
Effectively, the gold-silver ratio represents the number of ounces of silver it takes to buy a single ounce of gold.
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 a substantial profit potential exists in some established strategies that rely on this ratio.
Here's how investors and traders can benefit from observed changes in the gold-silver ratio.
The gold-silver ratio, also known as the mint ratio, refers to the relative value of an ounce of silver to an equal weight of gold. Put simply, it is the quantity of silver in ounces needed to buy a single ounce of gold. Traders can use it to diversify the amount of precious metal they hold in their portfolio.
Here's how it works. If gold trades at $500 per ounce and silver at $5, traders refer to a gold-silver ratio of 100:1. Similarly, if the price of gold is $1,000 per ounce and silver is trading at $20, the ratio is 50:1. Today, the ratio floats and can swing wildly.1
That's 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.
The gold-silver ratio has fluctuated in modern times and never remains the same. That's mainly due to the fact that the prices of these precious metals experience wild swings on a regular, daily basis. But before the 20th century, governments set the ratio as part of their monetary stability policies.
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 12:1.2 The U.S. government fixed the ratio at 15:1 with the Coinage Act of 1792.3
During the 19th Century, the U.S. was one of many countries that adopted a bi-metallic standard monetary system, where the value of a country's monetary unit was established by the mint ratio. But the era of the fixed ratio ended in the 20th century as nations moved away from the bi-metallic currency standard and, eventually, off the gold standard entirely.3 Since then, the prices of gold and silver trade independently of one another in the free market.
Here's a quick overview of the history of this ratio:
Despite not having a fixed ratio, the gold-silver ratio is still a popular tool for precious metals traders. They can, and still do, use it to hedge their bets in both metals—taking a long position in one, while keeping a short position in the other metal. So when the ratio is higher, and investors believe it will drop along with the price of gold compared to silver, they may decide to buy silver and take a short position in the same amount of gold.
So why is this ratio so important for investors and traders? If they can anticipate where the ratio is going to move, investors can make a profit even if the price of the two metals falls or rises.
The prices of gold and silver are most often reported per ounce.
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 rather than 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:
Note that no dollar value is considered when making the trade. That's because 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.
There are a number of ways to execute a gold-silver ratio trading strategy, each of which has its own risks and rewards.
This involves either the simple purchase of either gold or silver futures contracts, or buying one to sell the other if you think the ratio with widen or narrow. The main advantage (and also the disadvantage) of this strategy is the same—leverage. That is, futures trading requires only a relatively small amount of cash up front to place a much larger trade. This can be a risky proposition for those who are uninitiated. An investor can play futures on margin, but that margin can also bankrupt the investor.
ETFs offer an accessible and simple means of trading the gold-silver ratio. Again, the purchase of the appropriate ETF—gold or silver—at trading turns can be used execute your 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 in gold and silver are also available for investors, many of which involve a sort of spreading. For example, you can purchase puts on gold and calls on silver when the ratio is high and the opposite when the ratio is low. The bet is 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. Options, however, permit the investor to put up less cash and still enjoy the benefits of leverage with limited risk.
Options have a time decay component that will tend to erode any real gains made on the trade as time passes and the options contracts approach expiration. Therefore, it could be best to use long-dated options or LEAPS to offset this risk.
Purchasing physical gold comes with the added cost of having to store it. It can be a better financial decision to gain exposure to gold through funds and the stocks of gold companies.
Commodity 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 the actual metal can be attained whenever the investor desires. This is not the case with metal ETFs, where very large minimums must be held in order to take physical delivery.
It is not recommended that this trade be executed with physical gold for a number of reasons. These range from liquidity and convenience to security. Just don't do it. You can buy and hold physical gold and silver for long-term investment purposes, but it is very difficult and expensive to trade in and out of these metals in this way.
The gold-silver ratio is calculated by dividing the current price of gold by the current price of silver. This will show you which metal is increasing in value in comparison to the other.
The gold to silver ratio is not always high. It fluctuates over time depending on a variety of factors and can be quite low. In general, however, it is high because there is more demand for silver in the world than there is for gold. The use of silver is more widespread than the use of gold.
The current gold-silver ratio, as of August 2022 was around 89:1.4
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, and the ratio continues to expand—hovering for the next five years between 120 and 150—then 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 mid-term to catch the more likely extremes as they emerge.
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.
Originally published on Investopedia.
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