Today we will be looking at a different way of trading the precious metals market. Until now, we have talked about outright positions in the various markets. If we were bullish we bought, and went long. Conversely, if we were bearish we went short.
Now we will look at spreading, wherein we can simultaneously be long one contract and short another, hoping the ratio moves favorably. Let’s look at the gold/silver ratio. This spread is measured in ounces: how many ounces of silver it takes to buy an ounce of gold. Although silver mostly follows the same trend as gold, its volatility has historically exceeded that of gold. Generally, when the ratio is high, silver looks like the better buy because, relative to gold, silver is somewhat cheap. On the other hand, when the ratio is low, it means that gold is cheap relative to silver.
Currently, the ratio is 75:1, which indicates that it takes almost 75 ounces of silver to purchase one ounce of gold. Specifically, gold is selling at 1253, and silver at 1674, giving us that 75:1 ratio. Historically, in 1792, the gold/silver price ratio was fixed by law in the United States at 15:1. It remained in that range, around 16:1, until around 1900. This was probably because many countries were using gold- and silver-backed currencies. (France was another country that set a legal limit on the ratio.) Throughout the twentieth century though, the gold/silver ratio has averaged about 50:1, fluctuating wildly at times. Jumping to the present, the spread reached a peak of 85:1 towards the end of 2008. So today, trading at 75:1, it is still at the high end of the range.
Generally, the ratio can tell us several things. It tells us the market sentiment about industrial activity because, in addition to being a precious metal, silver has several industrial uses, among them the production of electronic items, and serves as a good indicator of how the economy is performing.
As I have mentioned many times in previous Market Comments, gold is used as a safe haven. The ratio tells us about the perceived need for protection as a hedge against inflation, as well as other political or economic forces. Additionally, the price of gold is primarily determined by investment demand, although investment demand is also an important factor in determining silver’s price.
So what is the ratio telling us now, with gold relatively high compared to silver? Certainly it can’t be current inflation or inflationary expectations, as inflation levels are generally low worldwide. But the recent interest in cryptocurrency is telling us something else. There is a lack of confidence in paper currency, and in the governments that back them. The relatively high price of gold to silver shows that fear “trumps” confidence in our economy. Silver is floundering. People are buying gold as a hedge against political and financial uncertainty. But the cryptocurrencies, which are now the ultimate hedge against the establishment, are being bought out of real fear. Aside from the recent correction, crypto prices have been skyrocketing. All of this is impacting the gold/silver ratio.
Ultimately, why would someone want to spread gold/silver instead of having an outright position in gold? Let’s take a look at the recent flash crash in gold on Monday June 26th.
During a ten minute period, 3 million ounces of gold futures traded on the Commodity Exchange (COMEX). The price fell from $1255 an ounce down to $1237 in a matter of seconds. Whether it was a “fat finger” or a “black box” occurrence isn’t really important. Eventually, gold recovered most of its losses. However, anyone with a close stop, lost their position. A gold/silver position without a stop probably would have fared better.
Playing spreads like the gold/silver ratio isn’t for everyone, but should be considered by anyone looking to maintain a longer term position.