Gold and silver have always been and will always be many investors’ favorite precious metals. The summer sell-off and subsequent bounce in gold and silver has reignited investment fever in the commodities.
Traders often substitute silver for gold because the two have a strong correlation with each other. However, the commodities are very different and should not be used interchangeably despite the seeming correlation.
Trading commodity futures is difficult. This is true even if you are on the inside. There is no such thing as illegal insider information in the commodity markets. Acting on information that would result in a lengthy prison sentence in the stock market is common — and considered an edge — in the commodity markets.
A firm might have many millions in capital combined with near perfect information on supply, demand and supply chain logistics, and it might even own large stores of a commodity, but it is not guaranteed success in the volatile commodity futures market.
Secondly, commodities that appear to be correlated don’t provide the same opportunities for investors. Specifically, correlation on a price chart doesn’t necessarily mean one metal can be substituted for the other in an investment account. The primary reason is that each commodity is moved by different price drivers.
Price drivers are the underlying factors that affect the price of a financial instrument. Obviously, supply and demand are the primary price drivers of any stock or commodity. Price drivers break the economic theory of supply and demand into actionable parts.
The price drivers for gold and silver are very different. Gold is primarily used for jewelry and investment purposes. On the other hand, close to half of all demand for silver is from industrial sources. This means that demand for silver is tied more tightly than gold to industrial growth.
Supply is also very different. Both silver and gold are mined directly, but silver can be a by-product of gold refining and industrial processes.
This chart shows the ratio of the number of ounces of silver required to purchase 1 ounce of gold over the past decade.