Why the gold to silver ratio counts
SIMPLY put, the gold-silver ratio represents the number of ounces of silver that it takes to buy one ounce of gold. The gold-silver ratio has the advantage of stripping out the dollar denominational aspect of taking a straight position on gold or silver. When you take a spread bet on the silver or gold spot price you are actually taking a position on the silver-dollar ratio or the gold-dollar ratio. Industrial demand for silver may jump, but if the US dollar strengthens at the same time, then price gains may be wiped out. When you take a position on the gold-silver ratio, the dollar denomination aspect can be ignored – though not for the purposes of the inversely correlated risk-sentiment link between gold and dollar performance.
EGYPTIAN ECONOMICS
The pairing is deep rooted in monetary history. Croesus of Lydia is thought to be the first to have issued a bi-metallic currency. It had two silver coins – one at 10.7g and the other 5.35g. A gold coin was issued weighing 8.04g. With the gold-silver ratio kept at 13.3, 10 large silver coins were equal to one gold coin.
This 13.3 gold-silver ratio was accepted by the Egyptians and the ratio traded at an average of 15 for the next few millennia. But it was not based on any highly complex fundamental analysis of the supply and demand of precious metals, but rather on the calculation that the silver moon moves 13.3 times faster across the heavens than the golden sun.
The ratio held the 15 mark for most of the 1800s, but hit 45 points towards the end of the century. It broke triple digits in the 30s and 90s but still managed to hold the 15 level on Silver Thursday 1980 when the Hunt brothers tried to corner the silver market, driving the price up to $48.70 per troy ounce before being ruined by a $100m margin call. (see chart, above right)
IMPROVING DEMAND
Improved US industrial production figures and Chinese macro data have given silver a jump of late, with gold taking a knock against its anti-US play.
In 2012, gold has returned about 13 per cent for the year-to-date, while silver has gained 27 per cent over the same time period.
Whereas gold has few industrial uses and so does not hit the same wall, analysts predict that silver prices could hit $45 an ounce before we see demand-side destruction.
As you can see from the silver supply and demand chart above, silver is heading for a supply deficit in the next 10 years, as increased industrial demands for the metal as well as increased investor interest means that demand will vastly outstrip supply. The metal is finding increased applications in food and water purification, solar technology applications, nanotechnology and medical applications. However it’s worth noting that the silver market is much smaller than gold – a $4 move in gold is the equivalent to the entire silver market.
TRADING THE RATIO
So how do you trade it? For liquidity reasons, it’s a difficult and expensive play for retail investors using physical commodities, but it can be done relatively easily by spread betting or contracts for difference (CFDs). However, providers do not usually offer the ratio as a standalone quote and so you need to take two positions, one on gold and one on silver. This also means paying for the stop loss on each of these trades.
Another alternative is through some of the new gold-silver ratio exchange-traded funds (ETF) that are cropping up. Last year, Horizons ETFs launched its Comex long gold/short silver ETF and its long silver/short gold ETF, the first commodity spread ETF to hit the market, giving a low cost way of following a pair-trading strategy.