Ratio trading gold and silver

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Published : January 05th, 2016
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Category : Market Analysis

In August I did an analysis of the ideal percentage allocation between gold & silver. This assumed one picks a percentage allocation and sticks with it. Another investing approach is to switch between gold and silver based on one’s view of which metal will outperform the other in the future. One way to determine the point at which to switch is to use the gold/silver ratio.

Below is a chart of the gold/silver ratio, calculated by dividing the gold price by the silver price. Another way of looking at this chart is that is shows the price of gold in ounces of silver.

24hGold - Ratio trading gold a...

On the chart I have marked some reasonable high and low trading bands based on historical movements in the ratio. When the ratio is high, it is saying that gold’s price in ounces of silver is high, so sell gold and buy silver (light grey line). When it is low, gold is relatively cheap, so sell your silver and buy gold (gold line).

It is important when dealing with ratios to keep in mind that they are just a relative performance measure. Switching between metals at a high or low ratio does not guarantee dollar profits, as the ratio can change when both gold and silver are falling in price (in which case it is just telling you which metal is losing you less money).

You can see from the chart above that in February 2011 the ratio broke through 45, which based on history looked like a reasonable ratio low and thus a signal to sell silver and buy gold. The ratio then had a relatively steady climb to 75 in November 2014, a historically high point and with some commentators suggesting silver will be the outperforming metal going forward based on this high ratio.

However, the chart below shows the dollar performance of gold and silver since 2011.

24hGold - Ratio trading gold a...

First, note that the ratio had you out of silver and missing its 50% increase. Gold still went up initially but you can see from the chart that while the ratio moved from 45 to 75 over nearly four years, both gold and silver fell over that time period. The ratio signal did “work” in the sense that gold did outperform, only falling 15% compared to silver which fell 49% between Feb 2011 and Nov 2014.

The other caveat is that the ratio trading bands (or any trading bands) are not guaranteed to work in the future. You will notice on the ratio chart that prior to the mid 1980s a reasonable gold:silver ratio trading band appeared to be 30 for a switch to gold and 40 to switch to silver. However in 1983 you would have got into silver at 40 waiting for the ratio to get back to 30 as it had done many times in the past 12 years but instead it only got into the low 30s before climbing to nearly 100 in 1992.

It should be clear from the chart that something structural or fundamental changed in the gold or silver market during the mid 80s to early 90s with gold and silver moving into a new “relative” relationship. Possibly that structural change was the decision by the United States to liquidate its Strategic Stockpile of silver, as detailed here, see the chart below.

24hGold - Ratio trading gold a...

Note that the rate of stockpile reduction increases from 1985 onwards, around the time the gold:silver ratio begins its dramatic run to 100, and that when the stockpile drops to its first low point in 1993 the ratio breaks below 90 (which it has never seen again).

The takeaway is don’t just trade a ratio purely based on historical numbers without some theory as to how the two assets are related and whether the environment in which that relationship exists is likely to continue in the future.

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