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Friday, October 04, 2024

Gold Silver Ratio

By Century Financial in 'Investment Insights'

Gold Silver Ratio
Shariah-Compliant Stock

The gold-silver ratio reflects the price relationship between gold and silver, showing how many ounces of silver are needed to match the value of one ounce of gold. Investors often trade this ratio by hedging their positions in one metal with opposite positions in the other

For instance, if the ratio is unusually high and investors expect gold's price to drop relative to silver's, they might buy silver while shorting the same amount of gold. If their prediction proves accurate, they could profit from silver outperforming gold.

Historical Scenario: A Series of Economic Recessions Following Rate Cuts

Source: Bloomberg
Blue line: Silver
White line: Gold

Historically, it is seen that gold moves up on an average of 34% during the entire rate cut cycle while silver declines. However, it is worth noting that all three of the historical rate cuts have been followed by a recessionary environment. This led to increased demand in safe haven asset such as gold, driving prices higher. Moreover, since silver’s predominant demand comes from industrial activity, historical recessionary environments prevented silver prices from rising as much as gold.

It is also observed that, typically, silver and gold move in tandem. However, a large divergence in prices has developed since 2013. The divergence has aggravated in recent times as gold started recovering due to increased demand from the COVID-19 pandemic, rapid central bank buying which reached historical highs in the past two years and increasing geopolitical tensions.

This has now set silver up for a potential rally as current macro-economic factors seem favourable towards the precious metal.

Current Scenario: A Soft Landing in Sight

During the September FOMC meeting, the federal reserve cut interest rates by 50 bps, bringing the fed fund rate to 5%. It is further expected that rates will fall to 4.4% by the end of this year and finally to 2.98% by 2026. Moreover, comments made by fed chairman Jerome Powell were very dovish stating the strength of the US economy and labor market. This has eliminated any risks of a recession and solidified a soft-landing scenario. This is expected to bode well for silver as industrial activity is expected to pick up as the economy heads for a period of strong growth.

Moreover, silver is currently in a deficit which is expected to continue till the end of the year. It is anticipated that Silver will face a deficit of 265 million ounces in FY24, making it the second highest deficit in 10 years. Therefore, high potential industrial and photovoltaic demand and reduced mining output will help push silver prices higher.


Another factor to consider is ETF holdings of the two metals. Gold holdings have reduced 2.6% to 83 million troy ounces YTD while silver holdings have increased 1.8% to 712 million troy ounces YTD. Further signaling that a silver rally is just around the corner.

Source: Bloomberg
Blue line: Gold
White line: Silver

 

Gold Silver Ratio Current levels:

The ratio is currently close to 84 and is expected to face a pullback due to improving silver dynamics. Moreover, the average gold/silver ratio is 80. Given that gold prices are near the $2,700 level, silver should ideally be near $34 to maintain the average ratio. Implying that it is currently around 7% undervalued.

It is worth noting that if the gold/silver ratio crosses the resistance level of 91.32, the trade should be exited.

Trade Strategy:

Current level of ratio is 84

Suppose we have a total investment of $500,000.

We take a long position in silver of $250,000 at $31.7/Oz i.e. 7,886 ounces.
We take a short position in gold of $250,000 at $2,662/Oz i.e. 94 ounces.

Below is a historical analysis of the gold silver ratio when it decreased from 84 to 80 and increased from 84 to above resistance level of 91. The trade is profitable only when the ratio is declining. If the ratio crosses the resistance level and we have taken the current trade strategy of long silver and short gold, we will suffer heavy losses. Hence, it is advised to exit the strategy at this point.

Ratio decreases to 80
Metal prices rise - November 2022
Position Quantity (Oz) Spot Price % change in price New price Profit/Loss
Long Silver 11,927 $20.96 141.18% $23.93 $35,450
Short Gold 142 $1760.44 8.50% $1,910.08 -$2,1250
Net Profit $14,200
 
Metal prices fall - October 2008 to November 2008
Position Quantity (Oz) Spot Price % change in price New price Profit/Loss
Long Silver 24178 $10.34 9.5% $9.36 -$23,750
Short Gold 294 $850 12.0% $748.00 $30,000
Net Profit $6,250
 
Ratio increases to 91.32
Metal prices rise - December 2019 - February 2020
Position Quantity (Oz) Spot Price % change in price New price Profit/Loss
Long Silver 14069 $17.77 0.82% $17.92 $2,050
Short Gold 167 $1,500 9.1% $1,636.30 -$22,750
Net Loss -$20,700
 
Metal prices fall - October 2008 to November 2008
Position Quantity (Oz) Spot Price % change in price New price Profit/Loss
Long Silver 10339 $24.18 8.55% $22.11 -$21,375
Short Gold 123 $2,036 0.8% $2,020.53 $1,900
Net Loss -$19,475
Risks and Assumptions related to Back-tested trading strategies
The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
The back-tested strategy might be at risk of data dredging, which is the behavior of testing multiple hypotheses at one time, resulting in picking the data that best supports your main hypothesis.
Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
Unforeseen events can lead to variation in performance from the tested trading strategy.
The tested result has been computed with price feeds available from Bloomberg.
The testing environment has not considered transaction or any other costs.
Trading indicators used for the purpose of testing has been provided by Bloomberg.
The strategy might suffer from data mining fallacy, selection bias and backfill bias.
A trading strategy that performs well on multiple datasets from one market (e.g., forex) might not perform as well in another market (e.g., stocks).
The strategy may not depict accuracy in terms of spread changes due to the spread-widening events.

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