Whether you firmly believe that the COVID fiscal and monetary response is about to unleash a tidal wave of inflation or simply want to have some tail risk protection for your portfolio, an allocation to precious metals is probably a wise bet. The conventional choice is to simply buy gold and that is certainly a sound idea.
Gold has held its bid relatively well making higher lows at the $1650 level after spiking to $2000/oz during the COVID summer of 2020. However as the yellow metal continues to consolidate we think that silver may be a better trade if the rally in precious metals complex is to come.
Silver simply has a much lower cost basis than gold trading at $26/oz vs. 1800/oz for gold making it accessible to a much wider investment audience. If the investment demand for precious metals rises the buying frenzy is sure to sweep silver higher on a percentage basis than gold. Silver is also a key input in solar and 5G – two modern technologies that are sure to provide some natural industrial demand going forward. But perhaps the best reason to favor silver is that the gold/silver ratio remains massively overvalued. Historically the gold/silver ratio has centered about 15 but in the 21st century it exploded to a high of 115 before finally coming off its record highs. Currently the gold/silver ratio is around 69 – still more than four times its historical norms and certainly has scope to decline towards 50 as the pricing between the two precious metals continues to rebalance. That suggests that a short gold/long silver spread may be the best way to play the inflation trade.
Here are three possible ways to trade the gold/silver spread.
Go long both but in different proportions.
If you are a firm believer that all precious metals will rally and do not want to make relative bets then you can simply go long both the GLD and SLV ETFs or the CFD derivatives but in one to two ratio owing two units of silver for one unit of gold. If silver does rise faster than gold the extra allocation will provide much better cumulative returns for that piece of the portfolio.
Long SLV/Short GLD in equal proportion
This is simply a pairs trade that at current price would require you to go along approximately 7 shares of SLV for one share of GLD to maintain an equal amount of each. The advantage of the relative strength trade is that it’s non-directional in nature. If precious metals decline instead of rising the trade could still make money as long as gold declines more than silver. Of course the risk of the trade is that gold could outperform silver in which case you could lose money even if both rise.
Long SLV and GLD LEAPs
Buying slightly in the money long term options of 6 months or longer duration on both SLV and GLD could offer you the best of both worlds. It would provide exposure to the inflation trade (which will either be obvious by that point or not) without tying up a lot of capital. As long as the options are 75 delta or better – meaning that at current prices they will move at least 75% in the direction of the underlying (that ratio will improve if the trade begins to work) then you would have the prospect of making a directional bet on inflation in a defined risk manner that could offer explosive upside if precious metals catch a bid.
