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Win Gold by Trading Silver

Using the Gold:Silver Ratio When Silver is High

Written by Briton Ryle
Posted February 24, 2014

Silver medals may take second place to gold in Olympic competition, but in the financial arena, silver has beaten all the precious metals in growth performance this year.

Check out the latest scoreboard, substituting copper for bronze:

  Dec. 21st Feb 20th Change
Copper $3.3965 $3.279 -3.46%
Palladium $718.30 $736.30 +2.51%
Platinum $1,373.80 $1,412.50 +2.82%
Gold $1,203.00 $1,316.90 +9.47%
Silver $19.370 $21.684 +11.95%

While athletes covet the gold medal, investor demand is for silver — pushing up silver's price to its best winning streak in 45 years, averaging gains of more than 1.6% each week this year.

So what's behind silver's outstanding performance? Will it remain atop the tallest podium in the winners' circle? One metric in particular is screaming, "Go, Silver, Go!" as it points to much higher silver prices to come.

It's a Relative Play

In this exposé, let's skip the usual background on supply/demand fundamentals and monetary policy concerns. Let's focus instead on how to make money trading — how we can get the most of our investment in precious metals regardless of whether they move up or down.

Believe it or not, you can improve your precious metals allocation simply by trading gold and silver against each other. It's based on the gold:silver ratio, and silver's performance is of Olympic quality for which it deserves a medal.

As we all know, silver is tethered to gold. When the yellow metal moves up or down, the white metal moves with it. But that tether is not a string; it's an elastic band.

As such, there are times when gold will move faster than silver, increasing the gap between them. The elasticity of the gold-to-silver ratio will suddenly snap silver forward, causing it to move faster than gold to catch up. This gives silver greater momentum than gold, causing silver to periodically outperform gold as noted above.

But that elastic tether works the same in the opposite direction, too. At some point, silver will have outpaced gold so much that any drop in the gold price will pull silver down faster than gold.

The follow chart comparing the SPDR Gold Trust ETF (NYSE: GLD) to the iShares Silver Trust ETF (NYSE: SLV) shows exactly what I mean:

Gold to Silver RatioClick Here to Enlarge
Source: BigCharts.com

Notice how the 2008 correction increased the gap between silver (black) and gold (gold)?

When traders realized silver was undervalued relative to gold, they piled into it with gusto in 2010, giving it a momentum that caused it to overshoot gold on a percentage basis and sending it soaring. By May of 2011, while gold was measuring a 130% gain over 2006, silver hit 240% over its 2006 price.

That is what is happening now. And the simplest way to profit from it is to trade the ratio.

Understanding the Gold:Silver Ratio

The simplest way to profit from this twirling waltz between gold and silver is to buy the one that is undervalued and sell it when it is overvalued. Even though both prices will move down together and incur losses to your combined allocations, the dollar-cost averages of the two investments will improve by sliding funds between them at the appropriate times and in the appropriate direction.

When are those appropriate times, and what is the appropriate direction? For this, we need a chart of the gold:silver ratio itself, as shown below.

Gold Silver Ratio ProtectionClick Here to Enlarge
Source: MacroTrends.net

The graph depicts how many ounces of silver can be bought with one ounce of gold. The lower the plot is, the cheaper gold is relative to silver; conversely, the higher the plot is, the more expensive gold is relative to silver.

Think of the graph as tracking the price of gold. The only difference is that instead of plotting the price of gold in U.S. dollars, it is plotted in ounces of silver. Currently, the ratio between the two registers 63.84, meaning that one ounce of gold can buy 63.84 ounces of silver — about the mid-way point historically.

The time to favor gold is when the plotline is low, and the time to favor silver is when the plotline is high. Let's consider the ratio's recent moves, starting from the 2008 correction.

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Trading the Gold:Silver Ratio — For Protection

In the 2008 correction, which ran from about March to November, gold and silver fell pretty much at the same rate during the first half. By July, their ratio had held pretty steady at 52.63, as noted in the graph below.

Long Gold and Long Silver

Click Here to Enlarge
Source: MacroTrends.net

But then silver started to sell off like gangbusters. By December, silver had fallen so much that the price of gold relative to it had skyrocketed up to 80.61. (Again, think of that number as tracking the price of gold. A higher number means more expensive gold.)

We can profit from these moves by using the five-year moving average (brown line) as a guide. Whenever the ratio is below the five-year average, you want to be long gold. When it is above the five-year average, you want to be long silver.

You want to buy the cheaper of the two, switching when the other metal becomes cheaper.

Let's run a simple calculation using the above 2008 example. If you had simply held on to silver from July to December, you would have lost $10 for each SLV share, or some 52%, as it fell from $19 to $9.

However, if you had switched to gold, which was below the five-year ratio average, you would have lost only 22% of your gold holding as GLD fell from $90 to $70.

Note that you would have still lost money during the correction. But the impact would have been much less severe simply by using the ratio as your guide.

Trading the Gold:Silver Ratio — For Profit

But we're not finished. We want to make a profit, not simply minimize our losses. The ratio trade can help you do that remarkably well during bull runs.

By the end of the correction in December of 2008, you would have switched out of gold and into silver, since gold was then well above its five-year average ratio and thus too expensive. You would have remained long silver until gold became cheap again, which happened after August 2010.

The result? If you had remained long silver until the gold ratio hit a bottom in April 2011 at 31.53 — when silver was near its all-time high of $50 an ounce — your silver position would have gained 433% as SLV rose from $9 to $48 from December 2008 to April 2011, while GLD gained only 114% as it rose from $70 to $150.

Let's put both legs together and compare what our combined return would have been based on a $1,000 investment across three different scenarios: if we had left that $1,000 in gold the whole way through from July 2008 to April 2011, if we had left it in silver, and if we had switched according to the ratio (holding gold in leg 1 and silver in leg 2).

  Jul 2008 Dec 2008 Apr 2011
GLD (straight through) $1,000 $777 $1,666
SLV (straight through) $1,000 $473 $2,526
Ratio (leg 1 in gold, leg 2 in silver) $1,000 $777 $4,148

Why did the ratio trade outperform? Because from July to December 2008, we were in gold, which fell less, and from December 2008 to April 2011, we were in silver, which rose more.

We can go on like that forever. Let's add a third leg now. In April 2011, a ratio of 31.53 told us to go long gold. By July 2013, a ratio of 66.79 told us to switch back to silver again.

If you had followed the ratio's cues and stuck with gold during leg 3, you would have lost only 23%, while a position in silver would have lost you 55%.

Trading the Ratio Incrementally

Of course, the above calculations are based on perfectly timing the tops and bottoms, which no human can do consistently. The best we can do is trade the gold:silver ratio as a number.

When the ratio number is below the five-year average, keep sliding a little bit out of silver and into gold every five or 10 ratio-points down. When the ratio number is above the five-year average, keep sliding a little bit out of gold and into silver every five or 10 ratio-points up.

Follow this rule, and no matter where you put the finish line, straight gold and straight silver positions will always be fighting each other for the bronze and silver medals — while trading the ratio number against its five-year moving average moves on to capture the gold.

As it stands currently, the ratio trade tells us to be long silver. It's the only game in town where silver is the better prize over gold.

Until next time,

Joseph Cafariello for Wealth Daily

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