
First, a definition of arbitrage as this means different things to different arbitrage participants.
In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit. An entity such as a bank or brokerage firm that engages in arbitrage is called an arbitrageur. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities, and currencies.
To the actual trade.
There is without a doubt a price differential between retail silver product such as 100-troy-ounce silver bars and the spot price for silver on the Futures Exchange. In fact, this presents a very good arbitrage opportunity for those willing to take the risk. This is accomplished by selling lots of 1000 troy ounces in 100-ounce bar increments and locking in the 1000-oz. Comex bars for delivery. This process is achievable and like all arbitrage situations will find some market participants willing to take advantage of this opportunity.
In essence then, you sell short the futures, and use the proceeds to buy physical silver thus the trade is self-financing and locks in a profit spread.
How many of us little guys can actually do this? Some, I’m sure, but, generally speaking this will be more trouble than it is worth. However, rest assured it will be done. Free money is always picked up by someone. Warren Buffett once transacted a similar trade in cocoa.
Ok, so how do we, the little guy profit from the big guys? Simple, read on.

We can see from this weekly chart that gold clearly outperformed silver from 1999 until 2003. The gold/silver ratio reached a high near 82 to 1 in early 2003. The trend has been down since then, meaning that silver has outperformed gold from 2003 to present, but not by much.
If we study this chart carefully, we see that silver has very recently jumped far outside the channel formation that I have drawn. To my thinking, this represents an opportunity to trade gold for silver. This is exactly what I did on August 19, 2008. The actual swap took place near the 62 to 1 ratio, and I expect the ratio to fall back into the channel formation and in the years ahead to continue its downward bias. This channel formation can also be used to swap silver back into gold, which is what I plan to do at some point in the future. This certainly is “trading,” but not in the traditional sense; it is physical reality—real metal is being handed across the counter.
If this analysis is correct then the downward pressure on silver futures [due to the aforementioned arbitrage] due to selling of futures to finance the arbitrage, and lack of short covering, due to the delivery of the physical, will correct the price of silver downwards.
Now I’m not at all convinced of the analysis, so I would really hesitate here, look at this data;




On a convergence based trade, assuming due to a falling silver price due to arbitrage operations, you would want to be SHORT silver but LONG gold. This plainly is far from certain. Had Gold been the red line and Silver the blue, then I would have been slightly more hopeful. Unfortunately in all timeframes this simply is not the case, thus you are looking for an increasing divergence. In the longer timeframes convergence, rather than divergence, is suggested.
If we look at the fundamentals in addition to the ratio analysis that this trade was predicated on. This analysis is somewhat dated having been posted earlier, however as a reference point on Silver fundamentals it may lend something to the analysis.
Investment money flooding into silver has overwhelmed poor fundamentals and helped it to outperform gold, but the tide could be turning for precious metals and the probability of large losses is rising.
Silver’s price falls in percentage terms are likely to dwarf those seen in gold, which some fund managers say has stronger supply/demand fundamentals.
“History shows that when you get a substantial correction in precious metals, silver falls more than gold … It’s a more volatile market and smaller in value terms,” said Stephen Briggs, analyst at Societe Generale.
One big reason behind surging prices has been the tumbling dollar, making commodities priced in dollars cheaper for holders of other currencies. The weak dollar also prompts producers to raise prices to protect profit margins.
Last week the dollar fell to record lows against the euro, to beyond $1.60, an event which has caused many to question whether further losses can be sustained and whether it has bottomed.
“The dollar is not going to keep on depreciating forever,” Briggs said. He expects gold prices to average around $900 an ounce next year from $1,025 this year and silver to average $15.50 compared with $19.20.
Financial uncertainty, which has underpinned precious metals since last August is to some extent becoming less important to investors seeking the higher returns stocks and bonds offer.
With a weakened case for holding precious metals, prices have started to slip. Spot gold is now around $893 an ounce compared with a record high of $1,030.80 on March 17 and silver at $17 from a 27-year high of $21.24.
Goldman Sachs recently said it expects to see gold prices at $835 an ounce in 12 months and silver at around $15.50.
RECYCLING
From the end of last year to March 17, silver prices surged by more than 40 percent, while gold was up more than 20 percent. Silver’s heftier gains were built on investor flows.
Barclays iShares silver trust, the biggest silver exchange traded fund listed in the United States, now holds more than 5,770 tonnes of silver, a rise of about 10 percent since the end of last year.
Gold holdings by New York-listed StreetTracks Gold Shares, the world’s biggest gold ETF, stand at 591 tonnes, down about 5 percent since end-December.
“Silver is probably going to fall more than gold in percentage terms,” said Wolfgang Wrzesniok-Rossbach, head of sales at German metals trading group Heraeus.
“From an industrial and jewellery point of view, there has clearly been a decline in demand. There has been a lot of additional material coming to the market in the form of scrap.”
More than 20,000 tonnes of silver were produced globally last year compared with around 2,500 tonnes of gold.
The surplus in the physical silver market is expected by some analysts to rise to around 2,500 tonnes from a surplus of around 900 tonnes in 2007. The physical gold market could see a surplus this year of 600 tonnes from 500 tonnes last year.
“Fundamentals come into play when prices are coming down,” said John Reade, analyst at UBS. “Silver doesn’t have gold’s fundamentals.”
ONE SOURCE OF DEMAND
Silver is often a byproduct of other metals such as lead, zinc and copper, where miners are trying to ramp up production with some success.
That means more silver on the market and together with scrap recycling, supplies are set to jump this year, while overall demand, including that from ETFs is expected to fall.
“Silver is very dependent on one source of demand — ETFs. You can’t get excited about silver in the same way as gold. Silver doesn’t really have the same cachet,” Briggs said.
“Demand from the photographic sector has been falling fast … It’s no longer an important source of demand.” For gold, the picture is somewhat different. Mine production is expected to hold steady this year, but analysts expect output in South Africa, a major producer, to fall over coming years because the ore that remains is deep and expensive to access.
Fabrication demand — jewellery and coins — is expected to continue unabated as rising incomes in emerging market countries such as China and India allow people to choose gold over silver.
The supply and demand curves for silver as a commodity have had over the last fifteen years extended periods of deficits. This is partly due to the fact that silver supply is in large part a by-product of other metal production, or from scrap.
Silver Supply;
Silver is mined world wide, much as previously noted from polymettalic mines.
Approximately 530 million oz mined each year
Approximately 230 million oz year from scrap [mostly jewelry]
Total production:
Estimated mine production…………………….62 billion oz
Bars & Coins……………………………………..21 billion
Jewelry…………………………………………..20 billion
Fabricated products……………………………21 billion
Silver Demand;
On the demand side, the price for silver is economically insensitive. This is due to the following characteristics of silver;
*price increases in silver can be generally passed onto the consumer
*price increases in silver do not impact profit margins
*world has large inventories of silver [5000 yrs+]
The interesting story with silver, is in the same way as gold, silver is traded as a financial asset. Silver, like gold has during periods of history acted as money or a currency of trade.
Currently silver trades in financial asset forms;
*Physical
*Futures
*Options
*ETF’s
*Common shares of production companies
Volume of trades;
Circa 50 million oz/150 million oz per day
Circa 30 billion oz/year
During the 1990’s this was substantially higher.
The Gold/Silver ratio [basis of trades]
This ratio has through traders lore been mooted to exist and be a profitable way to trade the two separate commodities.
The ratio has varied through history from a low of 14/1 to a high of 100/1
The fluctuations are quite high. Silver has had historically a more volatile price.
Historic Ratio’s:
Year…………………………..Ratio
1687-1777…………………14.5/15.5
1800-1900…………………15.0/17.00
1925……………………….29.7
1926……………………….33.1
1927……………………….36.5
1928……………………….35.3
1929……………………….38.8
1970……………………….20.5
1971……………………….26.6
1972……………………….34.7
1973……………………….38.2
1974………………………33.9
1975………………………36.5
1979………………………27.6
1980………………………29.6
1981………………………43.6
1982………………………47.2
1994………………………72.9
1995………………………74.8
1996………………………74.8
1997………………………67.9
1998………………………53.2
1999………………………55.9
2000……………………..55.9
2001……………………..61.9
2002…………………….67.3
2003…………………….74.2
2004…………………….61.3
2005…………………….61.5
% Changes in price [random years]
2003………………………Gold +12.5%………….Silver +35.9%
2004………………………Gold +7.0%…………..Silver +6.8%
Just as a point of interest, “The Wizard of Oz” was an allegorical tale depicting the political struggle between William J Bryan Vs W. McKinley in the US Presidential race and the issues surrounding the Silver Purchase Act 1890
At about this time there was available an arbitrage available between a Gold dollar, and a Silver dollar that could be bought for $0.60 [risk free profit of $0.40]
Valuation;
There are three equally valid methods of valuing silver. The first is on a commodity basis, the second on a financial asset basis and the third on an aggregate ratio basis.
Commodity basis……………………………Value = cost of production
Financial basis………………………………Value = inflation hedge
Ratio basis ………………………………….Value = aggregate ratio over 5 yrs
Ratio value =……………………………….65.0
[$662.0 * 65 = $10.18] thus @ $16.0 overvalued
Inflation value =……………………………$5.38
Commodity value…………………………..[no value calculated yet]
With Silver closing at $13.003/troy oz I would say that silver is currently very overvalued on a fundamental basis [financial] and is in speculative territory.
After I have calculated the *production value* a slightly clearer picture might present itself.
The production value of one of the higher efficiency miners and an aggregate cost basis of some randomly picked silver miners gave a production value of;
Production value = $3.90
Investment value = $5.38
Ratio value = $10.18
Spot price = $16+
Some rather large differences in the prices
The supply of silver from above-ground stocks on a net basis dropped by 4 percent in 2006 to 194.4 Moz. The decline was the result of a shift of net producer hedging to the demand side. Total scrap supply provided the market with 188.0 Moz of silver in 2006, virtually unchanged from 2005.
Supply from Above-Ground Stocks
(Million ounces)………………………………….. 2005………………………… 2006
Bullion
Implied Net Disinvestment…………………… -77.2……………………….. -64.5
Producer Hedging……………………………… 27.6 ………………………….-6.8
Net Government Sales……………………….. 65.9…………………………. 77.7
Sub-total Bullion ………………………………..16.3…………………………… 6.4
Old Silver Scrap………………………………. 186.4………………………… 188.0
Total…………………………………………… 202.7………………………… 194.4