HardAssetsInvestor

Written by Charles Armstrong  |

April 12, 2010

Building A Better Gold/Silver Ratio

Details

We use the greenback to improve on the simple gold/silver ratio model.

• Behind correlations between gold, silver and the dollar
• Building a better historical model
• How do you play a gold-silver-dollar spread?

 

Commodity traders love spreads. Not only do spreads (intra- or intercommodity) provide guidance for entry and exit points in our trades, they also make a lot of sense. When comparing different types of commodities, it's a straightforward mental leap to understand that a barrel of oil is worth so many mmBTUs of natural gas, or that a bushel of corn is worth about 1 1/2 bushels of oats, and so on. Furthermore, these spreads tend to be easy to derive; all you need is a few years' worth of data and an Excel spreadsheet, and voila, you've calculated your spreads.

No such spread is followed with as much zeal as the gold/silver ratio. We've talked about this ratio before in some depth, but suffice to say, over the past 100-plus years, the gold/silver spread per ounce has remained relatively constant at 30:1—meaning one ounce of gold can buy 30 ounces of silver. However, over the last 12 years or so, that spread has widened to about 60-to-1. William Jennings Bryan would not be pleased.

Now, many traders closely track where the spreads are on any given day; that is, if you think the 60-to-1 spread of recent years is accurate and stable, you want to know when the spread moves significantly away from that, and play accordingly. Be it 70-to-1, 30-to-1, etc., you can always play the spread by shorting one metal and going long the other.

However, if you're like me, it's not the spread that's the most interesting part of this picture, it's what causes the spread to move one way or the other.

 

Correlations Between Gold, Silver And The U.S. Dollar

Since they're both the precious metals investors tend to flock to as "safe haven" assets, gold and silver prices are highly correlated. Over the last five years, more than 75 percent of the change in value of gold can be explained by the change in value of silver. There appear to be two partially unique trend lines, but in general, when the price of silver goes up, so too does gold's:

 

 

Gold also has a high negative correlation to the U.S. dollar; as we've covered before, when the dollar improves, gold's appeal as a safe haven diminishes. But what's interesting is that even though gold and the dollar are highly correlated, and gold and silver are highly correlated, silver and the dollar, in fact, do not have as strong a correlation.