How to use gold-silver ratio as an investing tool

Gold-silver ratio, derived from the prices of the precious metals, is the relative value of one gram of gold to an equal weight of silver.

Simply put, gold price is divided by silver price to arrive at this number.

Taking the latest spot price of gold (₹50,738 per 10 grams and so, about ₹5,074 per gram) and silver (₹62,609 per one kg and so, ₹62.6 per gram) on the Multi Commodity Exchange (MCX), the gold-silver ratio is nearly 81.

Essentially, this means, by selling one gram of gold, 81 grams of silver can be purchased. The ratio goes up when the price of gold rises relative to that of the price of silver and vice-versa.

For instance, as an extension of the above example, say gold price rises to ₹5,500 per gram and silver price rises to ₹65 per gram. Now, the ratio would be little higher at about 85.

So, even as price of both the precious metals rose, the relatively better performance of gold lifted the ratio. Similarly, if silver outperforms gold, the ratio will come down. Notably, this ratio can change every day since price of both precious metals are influenced by market forces.

In general, when the ratio rises to extremely high levels because of better performance of gold, silver is expected to play the catch-up game at some point in the future. Consequently, the ratio drops.

Ratio as a strategy

Exchanging the metals physically is one way of trading the gold-silver ratio. Suppose an investor holds one gram of gold and say, the ratio reaches 100 (which is very high, historically speaking). The investor can opt to exchange one gram of gold for 100 grams of silver.

Suppose the ratio falls back to 50, the investor can then probably exchange 100 grams of silver for 2 grams of gold. Here, the price of each commodity does not matter as the relative price movement is captured by the ratio. Here, the investor would have made gains in the form of additional one gram of gold.

Another method can be trading in futures contract. Assuming the ratio is at 100. The investor can sell gold futures contract and simultaneously buy equivalent quantity of silver futures contract. If the ratio drops to perceived low levels, say 50, both the futures contract can be liquidated. After netting off, the investor would have made monetary gains here, unlike in physical transaction.

Shortcoming

While the decision-making process is very simplified, trading the gold-silver ratio does have shortcomings. The major drawback is defining the extreme levels of the ratio.

Consider this: The ratio has been largely oscillating between 45 and 80 since 2000. But the rally in gold price triggered by Covid-19 propelled the ratio to a historical high of 117 in March. Rather than retracting back, if the ratio stays at extreme levels for prolonged period of time or rises even higher, the desired outcome may not be achieved.

The investor should have good understanding of the product that he/she chooses to trade based on gold-silver ratio. For instance, trading in futures contract requires understanding related to derivative products such as margin requirements and contractual obligations .

In essence, while the gold-silver ratio can be a great tool to trade in precious metals, it should not be used as a sole tool as there is no optimum or correct ratio.