Volatility in bullion (gold, silver) prices has increased in recent times. Anticipation that the US will begin its cycle of interest rate hikes by the year end has resulted in plunging gold and silver prices.
Those who want to understand the direction of bullion prices mostly track global economic conditions, inflation expectations and the geo-political situation. But there is another indicator that is equally useful in determining where bullion prices are headed — the gold-silver ratio.
This is a ratio obtained by just dividing the price of gold by the price of silver. The resultant ratio value is the amount of silver required to buy one ounce of gold. Say, the current price of gold is $1,135 per ounce and the price of silver is $15.25 per ounce. The gold silver ratio is thus 74.42 ($1,135 divided by $15.25). It means 74.42 ounces of silver are required to buy one ounce of gold.
Interpreting the ratio
In general, the prices of both gold and silver move in the same direction. The gold-silver ratio movement is inverse to the movement in gold and silver prices. That is, when the prices of gold and silver decline, this ratio increases, and vice-versa.
An empirical study of the movement of this ratio since 1980 shows that 67 per cent of the time, a sharp fall in the price of gold and silver has resulted in a sharp rise in the ratio. Heightened volatility in declines causes larger price moves, resulting in the expansion of this ratio. Also, the ratio increases faster in declines since the fall in gold prices is relatively lower than the declines seen in the silver price, which forms the denominator in the ratio.
On the other hand, rallies in gold and silver prices have dragged the ratio lower about 70 per cent of the time. The rally in metal prices between October 2008 and April 2011 is a good example. During this period the gold price rose from $850 to $1,500 and silver went up from $10 to $47. This rally dragged the gold-silver ratio down from 84 to around 32 over the same period.
In both the scenarios, the direction of the silver price movement has a major influence in the ratio movement. This is due to the higher volatility in silver prices in rallies and declines when compared to gold price.
The movement in the ratio can be used as a trading/investment indicator, especially in silver. That is, once the ratio records a peak and starts reverse lower, then investments can be made into silver. Gold can also be bought in this scenario, but the return could be less than the investment in silver.
On the other hand, if the ratio starts to reverse higher from a bottom, then silver can be sold as the rally in the ratio would be driven by a steep fall in the silver price. In this scenario, one may not want to offload gold as the decline in gold price would not be as sharp as in silver. The best time to buy gold would be when the ratio peaks and begins reversing lower.
The catch here would be identifying the peaks and bottoms correctly in the gold-silver ratio. Charts and technical analysis can be used as a tool for this purpose.