The price of gold broke below $1,850 yesterday and quickly drove a move higher in the U.S. dollar. The level acted as strong support for the past months but failed to hold as more news about potentially effective vaccines against the COVD-19 hit the wires.
Gold acted the way it was supposed to act during the pandemic. That is, as a safe-haven product, protecting investors both from the unknown, as well as from potentially higher inflation.
However, the first part of this statement did not function as it used to. Investors add gold to a portfolio to obtain diversification benefits. More precisely, if stocks fall, gold should fall less – or even appreciate. In 2020, it moved in tandem with stocks, reflecting more the second part, the protection against inflation.
Silver has long been viewed as the “poor man’s gold.” Because it is cheaper, it replaces gold in many portfolios. Just like gold, it offers a stock portfolio the exact diversification that a 60-40 portfolio does (i.e., 60% stocks, 40% bonds). To many traders, silver is just an extension of gold – a pretty much valid statement.
Gold and Silver – Different Volatilities
Gold and silver have a direct correlation – a positive one. It means that when one moves to the upside, the other one follows. Or, when it moves to the downside, the other one moves to the downside too. However, the direct correlation is triggered by the move in gold.
Rarely will you see the price action on a silver chart diverging from the one seen on gold. Therefore, the difference between the two is subject to arbitrage opportunity.
Take the price action during the pandemic. At the start of it, in March, the price of gold dropped – but the price of silver dropped more, percentage-wise. And then, the price of gold recovered – and so did the price of silver. However, because silver dropped more than gold, the absolute performance for the years so far is bigger on silver when compared to gold, if we measure the move from the absolute low to the absolute high.
For this reason, the gold/silver ratio is a key element when trading silver. By the time it exceeds certain values, it means that silver exceeded the regular or average divergence from the price of gold. As such, traders focus on silver rather than gold for the simple reason that silver should make up the lost ground.