The ETF Basis Says Jump
Late last night, I posted the following commentary to the new Editorial Forum for The Metal Augmentor subscribers. I’m very inclined to think this is becoming solid evidence that the basis, at least as I’ve been interpreting it, has some predictive abilities. Note that the trades mentioned have now been invalidated but it may still be worthwhile to establish new positions near the $888 (spot) level in gold and $11.74 (spot) in silver with a stop just slightly below those levels. The monetary metals will need to hold these respective prices until the end of next Tuesday in order to maintain upward momentum.
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Those who attended the GSUL session in Canberra last November know that I like to use the gold and silver ETFs, the SPDR Gold Shares (GLD) and Barclays Silver iShares (SLV), to keep tabs on the basis in gold and silver. I’ll be posting some historical charts and information later, but for now I wanted to provide a sneek peak at the current situation.
First, however, I’d like to provide a bit of a background for those who have not seen my work in this area before.
The “ETF Basis”, as I call it, is the difference at any moment in time between the metal ETF price on the stock exchange and the spot price on the cash exchange where the ETF issues and redeems physical metal. GLD trades on the New York Stock Exchange big board and SLV on the NYSE Alternext (formerly AMEX). In the case of both GLD and SLV, the cash exchange is the London Bullion Market.
The difficulty in calculating the basis has always been capturing the precise price differentials at each moment in time and that is why I developed the chart overlay process. I’ve mentioned and demonstrated a few of these chart overlays to GSUL attendees as well as on the SILVERAXIS website. To my knowledge, there are few better ways to get a visual sense of what is happening with the basis.
The below charts represent the basis of the gold and silver ETFs as of yesterday, January 22, 2009. Click on them to enlarge.
[Charts avaiable only to The Metal Augmentor subscribers -- Sign up here:
http://www.metalaugmentor.com/subscriptions.php].
As can be plainly observed, the ETF price is higher than the spot price for both gold and silver. [Here is a hint. I like to look for changes in the charts after the London market closes at 11 AM EDT. This is because arbitrage by Authorized Participants (see below) between the two markets becomes somewhat more difficult once the London market is no longer open. Can you spot some differences in these charts after 11AM?]
In effect, the gold and silver ETFs are in backwardation against the spot market, meaning that there is an apparent excess of ETF demand over the amount of spot demand. Another way to state this is ETF investors are willing to pay a premium to spot prices in order to acquire the shares. This is not necessarily a preference for shares over the metal but rather represents a preference by both large investors (especially institutional investors who cannot purchase bullion) and general equity market participants to gain exposure to the monetary metals. In any case, the natural result of “ETF backwardation” should be that the ETF’s Authorized Participants (trading arms of bullion banks authorized to deliver physical metal to, or withdraw from, the ETF trust in exchange for ETF shares) will create demand in the spot market. Obviously this tends to be bullish for both gold and silver prices.
Indeed, it has been quite rare for the gold and silver ETFs to be in significant backwardation against spot prices since they have been launched. One of the most prominent instances occurred early last September in the midst of the credit crisis as AIG was being bailed out. In that instance, about a week after the ETFs went into substantial backwardation, the gold price exploded by almost $150 in less than 2 days. Perhaps not coincidentally, that was the most spectacular rise in the price of gold during the current bull market. Silver also did very well, rising more than $2.50 over the same period.
The current ETF backwardation has been sustained for more than a week, gradually increasing to today’s level. Although it is not a surefire indication of an imminent price rally all by itself, there are some corroborating factors present. One of these factors is the pattern of higher highs and higher lows that I discussed last week over at SILVERAXIS (unfortunately the blog is down at the moment). This is a recent chart pattern that started in late October and it would become dominant if gold could surmount $888 and silver $11.74, wiping out a longer term bearish pattern that goes all the way back to last March.
For the above reasons, I believe there is a substantial chance that gold and silver could be days or even hours away from an explosive move higher. In particular, I would look for an acceleration higher should the aforementioned $888 and $11.74 levels get taken out. On the other hand, if gold were to break $800 and silver $10.25 on the downside, the potential would be eliminated.
One way to trade the above scenario would be using your favorite gold or silver trading instrument whether it be the ETFs or otherwise, with a stop below $800 for gold and $10.25 for silver. Ideally, a significant move should materialize by the end of next week at which point it would be a good idea to take profits. If there is no rally and especially if $888 proves to be potent resistance, then it would be time to re-evaluate the trade.
A more speculative play would be to purchase the near expiration February COMEX or GLD call options. The COMEX options expire next Tuesday but the 900 strike price seems cheap enough ($150 per option at the close today). It could get even cheaper Friday should gold drop below $850. Ideally, I’d look to buy these call options under $100 later today (forget buying them on Monday regardless of how cheap they might get since there will be less than 48 hours until expiration). The GLD options, expiring on February 20, appear to be an even better deal at $135 for the 900 strike. They are still highly speculative but in my opinion they represent great bang for the buck.
Finally, it may also be worthwhile looking at March COMEX silver call options although these are likely to be more of a long shot. We’ve already been burned by the $18 strikes acquired last October (the archived report discussing this speculative trade will soon be posted at www.metalaugmentor.com/updates.php), which are now nearly worthless, and I am hesitant to add more fuel to a fire that appears to be pretty well smothered. There might, however, be some merit in the $15 strike call options especially if they can be acquired for under $250, as these could appreciate to perhaps $1,500 or more on a bold move in silver within the next week. Needless to say, this is very speculative as was the original purchase of the $18 call options.
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