Trade idea: gold vs. silver

While gold and silver share a lot of similarities – not least their status as safe haven assets – there are important differences between the two. Gold, for one thing, has much fewer industrial uses than silver, which can make silver a better bet when economic growth is strong.

The gold/silver ratio is a well-followed measure for investors, showing the number of ounces of silver you could buy with a single ounce of gold. When the ratio reaches 80, it is seen by some as a signal that silver is oversold.

One way of trading the gold/silver ratio is via a pairs trade. A pairs trade is a market-neutral strategy that mutes the impact of broader market movements. It does this by matching two correlated assets – just like gold and silver – and taking a long position in one and a short in the second.

It can also be applied to a pair of exchange-traded funds, currencies, stocks or options.

Pairs trade example

Say that silver has risen past 80 on the gold-silver ratio. A pairs trader would go long on silver, the weaker of the pair, while shorting gold. They would then close their position when the pair’s relationship had normalised.

Any profit comes through the price change between the two metals. The win-win would be for the long position to rise and the short to slip, but it is possible to profit in many market scenarios, whether it rises, falls, drifts or is volatile.  If the long rises more than the short, or the short falls more than the long, the trade will still be in profit.