What it is:
The gold-silver ratio is measure of how many ounces of silver it takes to buy an ounce of gold.
How it works (Example):
The formula for the gold-silver ratio is:
Gold-Silver Ratio = Price of Gold per Ounce / Price of Silver per Ounce
For example, let's assume that the price of gold is $1,500 an ounce today. The price of silver is $50. Using this information and the formula above, we can calculate that the gold-silver ratio is:
$1,500 / $50 = 30
Note that the ratio can rise either because the price of gold increased or the price of silver decreased. Likewise, the ratio can fall either because the price of gold decreased or the price of silver increased.
Investors can play the gold-silver ratio by trading gold and silver ETFs, investing in options, or investing in futures rather than acquiring actual bullion or coins. Industrial investors who have physical use for gold and silver have to consider the storage costs of the metals, especially for silver, which takes up far more room than gold per $1,000.
Why it Matters:
In our example, it takes 30 ounces of silver to buy one ounce of gold. According to the U.S. Geological Survey, silver is about 17.5 times more abundant than gold in the earth's crust, but the gold-silver ratio averaged 47-50 during the 20th century.
Various trading strategies exist according to the relative prices of the two metals. Generally, this means that when the ratio is high, investors tend to favor silver. When the ratio is low, investors tend to favor gold.
However, determining when the ratio is unusually high or low is difficult, and the ratio can remain stable for a long time, making switching from gold to silver and back again somewhat futile for short-term (or impatient) investors. Of course, the strategy provides an opportunity for investors to diversify their precious metals holdings, which also offer a buffer against inflation and market volatility.