We crunch the numbers on four different plays on the gold/silver ratio to see which one comes out on top.
A picture, it's said, is worth a thousand words. So take a look at the picture below and try to come up with a thousand words to describe what you see:
Gold/Silver Ratio Spread
The graph's title might offer a clue: It's a head-to-head comparison of trades based on the gold/silver ratio.
We've examined the ratio in a number of articles before, acknowledging that there's more than one way for investors and traders to capitalize upon their expectations for the outperformance of one metal over the other. We've never put the trades side by side, though, to illustrate the actual returns attainable or the risks undertaken. As you can see from the chart above, depending on the approach you take, you can see a BIG difference in returns.
The red line represents the return obtained from using futures (as described in "Metal Spreads Make More Money"), while the blue line describes the gain realized by using exchange-traded metals trusts.
Let's walk through the trades.
First of all, both approaches represent bets on a decline in the gold/silver multiple—the price of an ounce of gold denominated in ounces of silver. On Feb. 1, the price ratio, loco London, was 47.2-to-1. Investors anticipating silver to outperform gold—by either rising more or declining less—would have bought silver and simultaneously sold gold short through futures or exchange-traded securities.
Futures traders could have used the actively traded December contracts in a 3-to-2 ratio—that is, buying three silver contracts (CMX: SIZ) and selling two gold futures (CMX: GCZ)—to qualify for a 50 percent margin credit (see "Metal Spreads Make More Money" for the details). All told, the initial margin requirement would be $24,369.
Alternatively, exchange-traded metals trusts could be employed. For a capital commitment similar to the futures trade, 500 shares of the iShares Silver Trust (NYSE Arca: SLV) could be purchased for cash, while 100 shares of the SPDR Gold Shares Trust (NYSE Arca: GLD) could be sold short in a margin account. The 5-to-1 ratio, insofar as round-lots allow, commits equal dollar exposure to each metal. The capital invested on Feb. 1 would have included $13,935 for the long SLV position and a deposit of $6,540 to secure a short GLD position worth $13,080.
By April 12, after a nearly relentless run-up in silver's dollar value, gold's price had declined to 36.1 times that of silver, engendering the gains depicted in Table 1.
Table 1: Futures Vs. Metals Trusts
|Long 3 SIZ/Short 2 GCZ||625.4%||47.9%||4.46||Yes|
|Long 500 SLV/Short 100 GLD||22.1%||11.3%||1.04||Yes|
Clearly, these are not equivalent positions. Largely, that's because of the leverage available in the futures trade. Both legs of the futures trade are margined; only the short gold position was leveraged on the securities side.
The degree of leverage was greater with futures, too. Regulation T limits the loan value to 50 percent of the securities' value, while futures leverage isn't restricted by Fed rules. Leverage was further enhanced by the margin credit granted by the futures exchange's clearinghouse. No such breaks are available to securities investors.