Trading the Gold/Silver Ratio

Every hard-asset lover knows of the gold-silver ratio, but the average ham-and-egger out there may not be so familiar.

No matter – whether you’re an old hand or a newbie, we lay it out in full below.

We start with definitions…

Glad you asked, Dermott.

In a nutshell, the gold-silver ratio represents the number of silver ounces it takes to buy a single ounce of gold.

That’s it.

Simple enough, no?

So, hypothetically, when gold trades for $500 an ounce and silver’s at $5, traders refer to a gold-silver ratio of 100.

Today, the ratio floats, as both metals get buffeted about by the daily moves of traders.  But it wasn’t always so.

Throughout history, the ratio was fixed by governments seeking monetary stability.  Here’s a thumbnail timeline of that history:

• When Alexander the Great died in 323 B.C.E., the ratio stood at 12.5.
• During the Roman Empire it was set at 12.
• At the end of 19th Century – with the closing of the so-called ‘Bi-Metallism’ era – the fixed ratio of 15 came to an end.
• In the 20^th century, the ratio averaged 47.
• In 1980, at the time of the last great surge in precious metal prices, the ratio stood at just 17.
• In 1991, when silver hit its lows, the ratio peaked at 100 (!), and
• During the last decade, the ratio has ranged from a low of 30 in 2011 to its current highs of close to 90.

So what do we do?

The current ratio stands at what we consider an ‘extreme’ reading.

Have a look at a long term chart –

Not since WWII has the gold/silver ratio seen such highs.

And with Chinese industrial demand for silver currently on the cusp of refiring, we believe a trading opportunity has now been created.

How does it work?  I want to do that Sucker!

Remember that the goal of this trade is not to increase your dollar-value profit, but to accumulate ever greater quantities of metal.  That’s why it’s the preferred technique of the gold buggerer crowd and other hard money enthusiasts.

Sound strange?

Stay with me, bro…

Here’s how it works –

The essence of trading the gold-silver ratio lies in swapping out your holdings when the ratio swings toward historically significant “extremes.”

So, for instance, if you –

1. Own one ounce of gold, and the ratio rises to 100, you would sell your gold ounce for 100 ounces of silver.
2. When the ratio then contracts to an opposite historical “extreme” of, say, 50, you would sell your 100 ounces of silver for 2 ounces of gold, thereby doubling your initial holdings without paying a cent!
3. In this manner, you would continue to accumulate greater and greater quantities of metal, seeking “extreme” ratio numbers from which to trade and re-acquire the relatively ‘cheaper’ metal.

Note, again, that no dollar value is considered when making the trade.  The currency-based value of the metal is of no import whatsoever.

For those who worry about devaluations and deflations and other such currency SNAFUs – or even war – the strategy makes perfect sense.  Precious metals have a proven record of maintaining their value in the face of almost any contingency that might threaten the worth of a nation’s fiat currency.

But wait a minute.  There must be risks, too, no?

Certainly.

Successful execution of the trade resides in correctly identifying those “extreme” relative valuations between the metals.

If the ratio hits 100, for example, and you sell your gold for silver – and the ratio continues to expand, hovering for the next five years between 120 and 150 – you’re stuck.  A new trading precedent has apparently been set, and to trade back into gold during that period would mean a contraction in your metal holdings.

A bad thing.

So what to do in that case?

You could always continue to add to your silver holdings and wait for a contraction in the ratio, though when that might happen is never certain.

So do we.  But there’s risk everywhere, friends, and correctly calling the extremes is the the gold/silver ratio trade’s primary challenge.

So how do we minimize it?

Another excellent question.

First, there’s a need to successfully monitor ratio changes over the short and medium term in order to catch the more likely “extremes” as they emerge.  And that, we do.

Second, and more important, is choosing wisely your method of playing the ratio.

There are a number of ways to execute a gold/silver ratio trade strategy, each of which has its inherent risks – and rewards.

• First up, there’s Futures Investing, which involves the simple purchase of either gold or silver contracts at each trading juncture.

The advantages of this method: leverage.

The disadvantages: leverage.

That is, futures trading is a battlefield for the uninitiated.  You can play it with margin, yes.  And that margin can also bankrupt you.

Better have a solid whack of experience before you choose this method, we say.  And better still, don’t use margin.

• Exchange Traded Funds (ETFs) offer a simpler and safer means of trading the ratio.  Again, the simple purchase of an appropriate ETF (gold or silver) at trading turns will suffice to execute the strategy.

Tip: 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, and as it falls they buy gold.  This keeps them from having to speculate on whether “extreme” ratio levels have actually been reached.  Very sensible.

• Pool Accounts are large, private holdings of metals that are sold in a variety of denominations to gold and silver lovers. The same strategies employed in ETF investing can be used here.  The advantage of Pool Accounts is that the actual metal can be attained whenever you want.  Not so with metal ETFs, where dangerously large minimums have to be held in order to take physical delivery.
• Gold and Silver Bullion and Coins. While we like the idea of holding coins in principle, we wouldn’t recommended you execute the strategy with them, for a number of reasons, ranging from liquidity to convenience to security.  Trust us when we say: just don’t do it. 

• Finally, Options strategies abound for the interested investor, and the most interesting involves a zero premium hedge using either calls or puts at extreme ratio readings.

So, for instance, today, a trader might purchase a silver CALL and sell a gold CALL for the same price in an offsetting transaction that requires nothing spent up front.

The “bet” is that the ratio will decline with time, resulting in significant outperformance from the silver CALL over the gold, and a sizable profit before the options expire.

A similar strategy, of course, could be employed with futures contracts, but options are our preferred method, since they allow one to put up less cash and still enjoy the benefits of leverage.

Always.

The risk here is that the options expire before the ratio has a chance to fully contract.  It’s best, therefore, to use the longest dated options possible to offset such an eventuality.

For those interested in striking out on their own, there you have it.  Consider your options carefully, and always choose a strategy that comports with your risk profile and investing personality.

It’s good to have you on board.

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