How to use the Gold / Silver ratio to interpret precious metals
Among the many analytics that traders in precious metals often use, the gold/silver ratio is one of the most popular measures. The gold/silver ratio measures the ratio of the dollar price of one ounce of gold to one ounce of silver. The bigger question is what does this ratio signify and how to actually interpret the gold/silver ratio?
What is the gold/silver ratio?
Gold silver ratio is nothing but an equation between the price of gold and the price of silver. Currently, 1 oz (troy ounce) of gold trades at $1510 while 1 oz of silver trades in the international spot market at $18. That gives you a gold/silver ratio of 83.9. What this ratio effectively means is that one ounce of gold can be exchanged for 83.9 ounces of silver. This gold/silver ratio normally ranges between 50 and 80 but there are occasions when the ratio diverges from this range by a big margin. For example, when the gold/silver ratio goes sharply above the 80 mark, it is economical for traders to convert their gold for more ounces of silver. This increases the demand for silver, raises the price of silver and brings down the gold/silver ratio back to the range. In case of a sharp fall in the ratio well below the 50 mark, the traders prefer to convert silver into gold and that pushes up the gold/silver ratio back into the range. By looking at the gold/silver ratio vis-à-vis its historical range, tells how to trade based on mean reversion.
Why does the ratio fluctuate?
One can argue that both gold and silver are precious metals and hence they are also safe haven investments. Then why does the ratio fluctuate? It has to do with demand patterns. The price swings for gold happen more from central bank and ETF buying. That means gold is more of a hedge against uncertainty. Silver finds nearly 75% of its usage in industries like electronics and hence silver demand and price is more linked to industrial cycles. If you look back at the last 10 years of the gold/silver ratio, it has gone as low as 35 in 2011 and as high as 92 in 2019. How to play the metals using the gold/silver ratio?
Rather use it as a pair trade
When the gold/silver ratio had touched 35 in 2011, it was a signal to either buy gold or sell silver. While selling in silver would have been a great trade, a buy on gold would have been disappointing. A better way would have been to go for a pair trade where you bet on relative outperformance rather than on specific assets. Recently, in June 2019, the ratio touched a high of 92 and is still at around 83.9. How to take a call? Should you go short on gold; that may not be a good idea with global uncertainty high? Should you buy silver; that would work only when the economic cycle picks up? Like in previous cases, mean reversions of the gold/silver ratio can be best used for designing pair trades!
