As the digital currency markets continue to mature and build trade history, we can learn more about market reactions, patterns and influences. Often cited as the digital version of gold – a finite, non-state wealth store – bitcoin may be joined in the world of nouveau analogies by litecoin, which has already become commonly referenced as digital silver.
Litecoin (LTC) is nearly identical to bitcoin with a few notable exceptions. Litecoin uses a different proof-of-work algorithm chosen specifically to make mining possible with consumer-grade hardware. Additionally, the LTC protocol targets 2.5 minutes average block times (compared to 10 for BTC) and is set to issue 84 million total LTC (compared with 21 million total BTC).
BTC and LTC, like gold and silver, have similar macro demand drivers, trade with a high correlation, and maintain banded ratio patterns. The implications of this for traders can be significant as time-tested strategies become increasingly applicable to these new, digital asset classes.
The Gold-Silver Ratio
In the world of precious metals trading, the gold-silver ratio is a commonly referenced metric. This ratio measures how many ounces of silver are required to purchase one ounce of gold based on their prices relative to an intermediary asset – generally USD. While gold and silver have historically traded with a high correlation driven by safe haven demand and inflationary concerns, they also each have their own price drivers.
Gold is primarily used for investment/speculation. Silver, while also used heavily for speculative and investing purposes, is more heavily used than gold for industrial purposes such as photography, battery production and electronics. This is important for two reasons. First, while silver is approximately 17 times more abundant than gold, it is also consumed by many of the uses that give it value. The utility difference also explains why the gold-silver ratio tends to see interim peaks during recessionary periods as demand for gold as a safe haven rises, while demand for silver in industrial production falls.
Silver is also roughly 50% more volatile than gold, depending on the period measured. As a result, the gold-silver ratio tends to move inversely with gold prices. When gold prices go up, silver prices generally go up more. This reduces their price differential (GSR). When gold prices fall, silver prices tend to fall more dramatically, increasing the GSR.
While fundamental factors like the ones listed above cannot be overlooked, investors will generally watch the GSR as an additional data point. Since the GSR tends to trade within a banded range, history tells us that if it slips too far from the mean then a correction may be on the horizon.
One of the main attractions of trading this metric is the ability to take a positive or negative view on gold or silver individually, while remaining long in precious metals in general, since invested capital never actually leaves the metals market.
Bitcoin and Litecoin
As the digital currency markets continue to mature, we may observe similar trends develop across assets. In particular, the relationship between bitcoin and litecoin may offer market insight unavailable from observing just one or the other.
Before continuing, it should be noted that precious metals markets have hundreds of years of data to observe whereas the digital currency world has but a few. Any trends should be assumed as potentially developing, rather than historically definitive. That being said, there are already a number of bitcoin-litecoin patterns worth comparing and contrasting with gold and silver.
BTC and LTC share similar demand drivers such as infrastructure growth, media mentions, regulatory actions and other newsworthy developments. Like gold and silver, what is good for bitcoin is good for digital currency in general, and visa versa. As a result, BTC and LTC prices tend to trade with a high correlation, much like gold and silver. Also similar is the fact that, like silver and gold, LTC will be far more abundant than BTC.
In contrast to the differing utilities of gold and silver described above, BTC and LTC have effectively identical real-world application. They both offer near-instant, near-free monetary transfer for any amount to anyone in the world with an internet connection. While the potential value of such a concept is immense, there is little functional demand differentiation to drive volatility in the BTC-LTC ratio.
Conversely, adoption is beginning to vary greatly, which could cause prices to separate further than they already are. As bitcoin continues to be accepted by ever-more merchants like Reddit, WordPress, Khan Academy and more, its functionality shifts from potential to reality. As more entities adopt the currency, it’s value should grow – a scenario that could destabilize the BTC-LTC ratio.
The alternate side to that argument might say that litecoin, which has yet to see any mainstream adoption growth, may still grow in value with bitcoin regardless of broad acceptance. A trustworthy alternative may be useful to anyone looking to easily conduct a cryptocurrency transaction off the bitcoin block chain. As the value of BTC rises, so then would the value of LTC.
Much like the GSR, trading the BTC-LTC ratio allows an investor to stay long on cryptocurrencies while simultaneously exercising a bullish or bearish view on individual coins. Over the last four months, since the April bubble, a visible trading band for the ratio has begun to emerge. Also worth noting is that volatility analysis between the two cryptos is far less definitive than between gold and silver, though that may change as volume increases and trading becomes less choppy in both markets.