Gold To Silver Ratio: Not Learned In School, But Well Worth Monitoring

Summary

Silver to gold ratio approaching 70:1.

Perhaps a correction short term in metals? Looking out several months, where from here?

Is Gold too high or Silver too cheap?

If you have made the decision to incorporate silver or gold into your portfolio, would you be better off buying one metal vs. the other? Or if you want to buy both, how do you split the purchase? Not to complicate your life, but what about buying one and selling the other? A strategy called in the futures market an intercommodity spread. A strategy in which a futures contract (call it silver) of a given delivery month (call it December) is purchased and, simultaneously, a futures contract of the same delivery month of a different (but usually associated) commodity (call it gold) is sold. The objective is to benefit from the changing price relationships of the two commodities.

The Gold to Silver ratio: For experienced metal investors, the gold to silver ratio is one of many indicators used to determine the correct and incorrect time to buy or sell precious metals. Other considerations may include inflation/deflation concerns, seasonality, economical uncertainty, and desire to diversify out of traditional investments, just to name a few.

So what is the Gold to Silver ratio and why does it even matter? By definition essentially, the gold to silver ratio is the amount of silver ounces it takes to purchase one ounce of gold.

At the time this was written (8/5/16), the gold to silver ratio stands at approximately 68 to 1. This includes today's trade, whereby silver fell by 3.4% and gold declined by 1.8%.

That means, at the current price, it would take 68 ounces of silver to buy 1 ounce of gold. Looking at the December 16' respective contracts, the current price of December gold sits at \$1344/ounce, while December silver is currently trading at \$19.90/ounce.

Simply take the price of gold, divide it by the price of silver and there you have it -- the gold to silver ratio.

Here is an example using recent market prices:

\$1344 (December futures gold price) ÷ \$19.90 (December futures silver price) = approximately 68 (Gold to Silver Ratio)

So what do I do once I have the ratio? Investors who trade gold futures, silver futures and other precious metals scrutinize the gold to silver ratio as an indication for the right time to buy or sell a particular metal. When the ratio is high (above75), the general consensus is that silver is undervalued. This is because, relative to the ratio, silver is somewhat inexpensive. Conversely, a low ratio (closer to 40) tends to favor gold and may be a signal it's a good time to buy this precious metal. Active investors may monitor this ratio to know when to establish a heavier position in one metal vs. the other or potentially be long/short against one another. Unfortunately, because the gold to silver ratio fluctuates so wildly (every day), it can be difficult for novice or small retail investors to read the signals and implement the correct investment position. Ideally, taking a step back and looking at the big picture will help drown out the day to day noise.

The concept of investing into metals serves as an impetus for diversifying one's portfolio. If one investment class underperforms, alternative investments in your portfolio like gold and/or silver have the ability to pick up the slack -- or losses. One key reason why investors incorporate individual commodities like gold and silver and Managed futures into their portfolio. Managed futures are like hedge funds where by the manager's trade on behalf of their clients in metals, energies, agriculture, to just name of few of the sectors they focus on. Curious? For more information check out our alternatives blog.

Let's jump in a time machine and go back several hundred years. Historically, what did the gold to silver ratio look like? Since the late 1600s -- as far back as the records reach (that I could find online) -- the gold to silver ratio fluctuated between roughly 14 and 100. Around 1900, the ratio stabilized, remaining relatively flat just under 20. This was likely because many countries were using gold and silver backed currencies. For instance, the United States among others assigned statutory limits on what the ratio could be. Also, the US Geological Survey estimates that there's 17.5 times more silver in the Earth's crust than gold, which could provide another explanation for the pre-1900 gold to silver ratio average.

Throughout the twentieth century though, the gold to silver ratio has hovered around 50 and has fluctuated wildly at times.

See gold to silver ratio in chart below from 1975 to the current.

Disclaimer: Past performance is not necessarily indicative of future results.

What does this mean for the future? Some experts predict the gold to silver ratio will return to its long-term, pre-1900 average of 16:1. Take that with a grain of salt though as it's worth noting among these experts are some of the most zealous advocates for silver investing. Is there such a thing as silver bugs?

In the end, for the ratio to return to its pre-1900 average, the price of silver would need to rise to approximately \$85/ounce (never seen). Likewise, if the ratio were to drop to its long-term average, silver prices would rise to about \$27/ ounce (last trade at that level 4/2013).

The gold to silver ratio is one of several valuable tools used to determine the optimum time to buy and sell gold or silver futures. However, it is wise to avoid haste. Only the experienced investors make profits using a short-term view, and even they suffer errors in judgment. My advice is to exercise patience, ample research and a long-term view, you may use the ratio to help determine timing in your gold and silver trading but with only a portion of your portfolio as this is just one idea -- again diversification is critical.

Silver:

Disclaimer: Past performance is not necessarily indicative of future results.

Silver prices started 2016 just under \$14/ounce and has been on a steady appreciation with only mild setbacks that were met with buying support. December futures traded to as high as \$21.25 in early July before setting back to current trade just under \$20/ounce. That's puts the appreciation ytd at just better than 40%... not too bad. Prices may have hit an interim top this week as we've experienced a violent correction the last 3 sessions with silver losing better than 5%. Next support is seen at the most recent consolidation level near \$19.40/ounce followed by 38.2% Fibonacci retracement dragging prices back near\$18/ounce. I would not rule out that trade in the coming weeks. Bulls may not want to hear this, but a trade to the 50% Fibonacci level at \$17.30 would do no longer-term chart damage maintaining the uptrend that begun late March/early April.

Gold:

Disclaimer: Past performance is not necessarily indicative of future results.

Much like silver, gold has enjoyed an upward trajectory in 2016 appreciating from \$1065/once to current trade at \$1340, higher by 26%. Around the same time in early July, silver was making 2016 highs and gold traded as high as \$1385/ounce, the highest trade since March of 2014. Interestingly enough looking at a weekly chart taking the all-time highs established in 2011 above \$1900/ounce and the low in 2015 \$1370/1380 represents a 38.2% Fibonacci retracement. You may be observing that generally both metals are moving in the same direction. Not necessarily on a daily basis but looking at weeks or months at a time it is very rare to see one metal appreciate while the others depreciate. What you will detect though is that they can advance/decline at different velocities, which will affect the ratios. For example, let's look at three points in 2016:

Ok so I have mentioned Fibonacci a handful of times in this piece. Who is this guy? A Fibonacci retracement is a term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going higher). Fibonacci retracement levels use horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before the trend continues in the original direction. These levels are created by drawing a trend line between the high and low and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.

Conclusion:

Takeaway: while the path of least resistance in the short run may be down for both metals, those that use the gold to silver ratio as a buy/sell indicator as this number gets higher a long silver/short gold position becomes more interesting. I will be looking for an entry above to 70 to 1. On a trade closer to \$18/ounce in December silver and \$1260/ounce in December gold. Let's see if you paid attention above:

\$1260 (December futures gold price) ÷ \$18.00 (December futures silver price) = approximately 70 (Gold to Silver Ratio)

RISK DISCLAIMER:

You should fully understand the risks associated with trading futures, options and retail off-exchange foreign currency transactions ("Forex") before making any trades. Trading futures, options, and Forex involves substantial risk of loss and is not suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources. You may lose all or more than your initial investment. Past performance is not necessarily indicative of future results. RCM Alternatives is a registered 'dba' of Reliance Capital Markets II LLC.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.