Gold-Silver Ratio Bounces from Support Level

Originally published in Business Standard, May 12, 2011.

The gold-silver price ratio, which has fallen drastically over the past few months, bounced from a support level last week when the precious metals sold off. This indicates relative weakness in silver versus gold.

The ratio measures the difference between the prices of gold and silver. The lower the ratio, the lesser the differential between the prices. In late 2009, the ratio peaked near the 85-level, when gold rallied due to the financial crisis but silver didn’t. A few days back, the ratio bottomed near 32, when both the precious metals sold off.

The sell off in the gold and silver markets is, of course, a reaction to the dollar bouncing from support. However, the widening of the gold-silver price ratio is interesting. Analysts have differing opinions on the direction of the ratio, with some predicting it to widen and hover around the 55-range for a next few years. Others predict it is headed to 20.

Before we get into the direction of the ratio, let’s look at the past trends to glean some information. The most recent peak of the ratio was near the 85-level, when gold prices far outperformed silver. The turning point of the ratio was a previous peak near 85, in the middle of 2003.

The current bounce in the ratio, from the 32-level, was due to a support level formed in that area in 1984. The ratio closed at 39.41 on Tuesday, after bouncing to 42. The 10 point bounce resulted from a relatively greater fall of silver compared to gold. In case the current low of 32 is broken, the next level of support is at 15. A fall to 15 will narrow the price difference between the two metals substantially. Since 1975, the range of the ratio was between 15 and 100.

From a medium-term perspective, the closest support and resistance levels are 32 and 50, respectively, with 32 being the most recent low and 50 being the area from where the ratio declined since January 2011, after consolidating for some time. Remember that the ratio going up or down is not an indication of where the price of individual metals are going, but the difference in their prices. For instance, the price of gold and silver can fall, like it did last week, but the ratio can rally if silver falls more than gold. Had gold fallen more, the ratio would have fallen.

Investors use the ratio to decide which of the two metals makes for better investment at any given point. When the ratio hits resistance, it’s good to switch from gold to silver and vice versa. Now, we will look at the levels of 32 and 50. If the ratio hits 32, it would be prudent to shift positions to gold and with the ratio near 50, silver would be a better bet. However, remember to use the ratio only as a secondary tool to make investment decisions. Price must always be the primary tool.

However, there are several traders who play off the fluctuating price differentials between the two metals. Bob Dunn is a proprietary trader and also a trading instructor at the US-based Online Trading Academy. He has a unique approach of spread trading gold and silver. If he anticipates silver to rise faster than gold, he would short gold and go long on silver. The rationale is that since silver will rise faster than gold, any loss in gold will be more than compensated with the rise in silver. However, if silver crashes, the profit from the short gold position will minimize losses. Essentially, gold acts as a hedge. Spread trading requires keeping a close watch on the gold-silver price ratio.

As to the actual price of gold and silver, it’s prudent to keep an eye on the dollar, which is bouncing for a strong support level. Since the dollar has sold off for quite some time, it could now have a strong correction, which is bearish for the precious metals. We would keep an eye on the resistance levels on the dollar index to anticipate turning points in the greenback. At the time of writing this article, the index is near the 74.5-level and the next resistance level is at 75.5, followed by 76.25 and 77.25.

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