How to Trade the Gold-Silver Ratio
Dear Rich Lifer,
On March 18, 2020, the gold-silver ratio hit an all-time high of 126.43.
According to one precious metal expert, this is the highest the ratio has been in over 5,120 years!
Why should you care?
First, let’s explain what exactly is the gold-silver ratio. The gold-silver ratio is how much silver it takes to buy a single ounce of gold. In March of last year, you needed 126.43 ounces of silver to buy just one ounce of gold.
As of writing this, the ratio has dropped to 67-to-1. When the gold-silver ratio falls, it usually means silver is outperforming gold. When the ratio rises, gold is outperforming silver.
What’s also worth noting is the gold-silver ratio is based on spot prices, so you’ll need to take that into account if you plan to trade the spread, which we’ll explain in a second.
So, why does the price of these metals fluctuate so wildly? The reason is simply because gold and silver are valued daily by market forces, but this was not always the case.
History of the Gold-Silver Ratio
Before the 20th century, governments set the ratio as part of their monetary stability policies. For hundreds of years, the ratio was fairly steady, ranging from 12:1 to 15:1.
The Roman Empire set the ratio at 12:1 and in the Coinage Act of 1792, the U.S. government fixed the ratio at 15:1.
During the 19th century, the U.S. and other countries adopted a bi-metallic standard monetary system, where the value of the country’s money was established by the mint ratio.
This came to an end by the 20th century when nations moved away from the gold standard entirely. Since then, the prices of gold and silver have traded independently of one another.
Although there’s no fixed ratio now, the gold-silver ratio proves to still be a useful tool for seasoned metal investors.
Some traders will hedge their bets in both metals by taking a long position in one and keeping a short position in the other. So, if you perceive the ratio to be high, you might consider buying silver and taking a short position in gold, assuming the price will fall.
If you can anticipate which direction the price is going to move, you can make a profit both ways.
Regression Toward the Mean
You’re probably wondering how you can predict which way the price will go? You can’t. But a lot of traders believe the ratio will always regress toward the mean. So, this is a clue as to which way the price might go, but you should always take into account other relevant economic factors as well.
What is the mean? It’s tough to say, some investors refer back to the ratio set in 1792 at 15:1, others believe it’s around 47:1, and lots of investors now think the “new” average might be between 50:1 and 70:1.
How to Trade the Spread
Before we explain how to trade the spread, it’s worth mentioning that investors trading the gold-silver ratio are not typically looking to make a dollar-value profit.
These gold bugs are more interested in accumulating mass quantities of the metals. Here’s how it’s done:
You start by buying one ounce of gold. Over time, the ratio may rise to an extreme of 100:1. At this point, you decide to sell your ounce of gold for 100 ounces of silver.
A year later, the ratio falls to 50:1, so you sell your 100 ounces of silver for 2 ounces of gold. And you repeat this cycle where your goal is to accumulate as much metal as you can.
In this regard, the actual dollar value of the metals is not important. Precious metals have proven throughout history to maintain their value in times of uncertainty, especially when a nation’s fiat currency is being threatened.
If you’re worried about currency devaluation, deflation, or even war, trading the gold-silver ratio is a sound strategy to ensure you’ll always have a stash of metals.
The Downside to Trading the Spread
Like any trade there are risks involved with trading the spread. Specifically, you run the risk of choosing the wrong direction the price is going to move.
For example, if the ratio is at 100:1 and you decide to buy silver, there’s a chance the ratio climbs up further to 110 and stays there for several years.
If you were to trade back to gold at 110, your stack would be smaller. So, you wait it out, buying more silver, and hoping the ratio contracts. But there’s no guarantee.
Another way to trade the ratio if you’re not interested in accumulating physical metals is through exchange-traded funds (ETFs).
Trading Gold and Silver ETFs
The same way stocks are traded, you can trade gold and silver ETFs. It all depends on your strategy and goals.
For example, you can trade the gold-silver ratio by buying iShares Silver Trust (SLV) and SPDR Gold Shares (GLD). The same rules apply. In fact, trading ETFs is actually much easier since you don’t have to worry about storage of the precious metals.
But, this is also the downside to trading the spread with ETFs, you don’t actually own any physical metals. Rather, you have an investment on paper that’s value is based on the underlying metal.
If your goal is to hedge against deflation and currency devaluation, trading ETFs might not be the best approach. But if you’re looking to diversify your retirement portfolio, this strategy can prove successful.
Learning how to trade off the gold-silver ratio can deliver profits even when the price of the two metals fall. Investors who understand this special relationship can find opportunities no matter the price.
To a Richer Life,
The Rich Life Roadmap Team