Today In Silver

After not updating its silver holdings for a week, this afternoon Barclays finally reported its current position at just north of 200 million ounces. That appears to be an addition of 2 million ounces on top of the 198 million ounces as of the last reported date, August 11. I happen to know, however, that SLV had actually disposed of 2 million ounces sometime last week. So, today’s addition is actually 4 million ounces. The historical data has not been updated to reflect this, so you’ll just have to take my word for it right now. In any case, the fact that SLV only reduced its holdings by 2 million ounces as silver dropped almost $4, and then added 4 million ounces at a level we hope will be a bottom, is somewhat encouraging. Moreover, it supports the contention that this selling episode has been overwhelmingly in paper COMEX silver and not the “real thing”.

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After an initial jump overnight Sunday, gold and silver refused to give up much of their gains as the trading day progressed, even though oil was wobbly and the dollar moved significantly off its lows. This is not necessarily a sign that hope has been restored to the market. There are still some significant risks that remain (some of which I’ll try to address shortly), but the price action does seem to indicate for now that fresh buyers could be gaining the upper hand.

The silver price is now almost $1 off its intraday bottom from last Thursday-Friday. Normally, this is an area where we should exercise some discipline (wait and see). With September COMEX option expiration a week away, however, here is a trading idea that might be worth a bit of skin. I think this might be a better play over the next several days than being outright long or short futures.

Assuming we get the least semblance of price stability into Wednesday night, look to buy a long strangle in September COMEX silver for under $1,000 at the open on Thursday. A long strangle involves buying both a call option and a put option. In this case, assuming the silver price remains in the low-13’s and high-12’s for the next couple of days, it might be possible to build the strangle using the 13.50 call and 12.50 put. Today, that long strangle would have cost us over $2,000 but in a couple of days it could drop near $1,000. I wouldn’t stretch the straddle much more than a $1 range as the odds of a losing trade will increase exponentially. I like to evaluate this type of trade using Bollinger bands, but there are other approaches that work as well.

This trade won’t require holding your breath for very long: it will expire worthless next Tuesday if the silver price stays in the $12.50 - $13.50 range. On the other hand, if we get renewed volatility into contract expiration, something that seems rather likely in my opinion, the potential profit is significant. You already know that I like to have at least the potential for a 10 times return on a one-way option trade. In the case of a two-way trade like this strangle, the potential I look for is a 5 times return. The $12.50 - $13.50 strangle could be put on autopilot by entering both a buy limit order at $11.50 and a sell limit order at $14.50 in September COMEX silver futures.

If one of these limits were to be hit, the trade would generate a $4,000 profit (just shoot me, that’s only a 4 times gain). If both of these were to be hit (the order is irrelevant), the minimum profit would be $9,000. I say minimum because the two limit orders would effectively cancel each other out, leaving further upside to both the call and the put. Of course, this would require the lucky trader to manually close out whichever option should remain in-the-money at expiration.

The $11.50 - $14.50 limits should be progressively pulled in toward expiration with the buy eventually increased to $12.30 and the sell reduced to $13.70 by next Monday. Hitting either end of this reduced range prior to next Tuesday market close would cover the cost of the strangle. Note that I’ve excluded commissions from these calculations.

You can try something similar in the September GLD options. They have more legs but that will cost you. One idea would be to start with a single strangle “unit” and add “units” every few days as long as gold remains in a tight range. Limit orders in GLD itself could be used to place the trade on autopilot.

Both of the above trades are for speculators only, and only those speculators who can’t stand being out of the market at this historic moment, yet who must also have defined risk. For such traders, it would be healthy to view the price of the strangle as the cost of admission. No pain, no gain.

What do you think?

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I haven’t talked about silver “lease” rates in a while, but this morning’s spike from very low and even negative levels to around 2% deserves some discussion. For those of you who have forgotten, the “lease” rate is the arithmetic difference between LIBOR and the forward rate on spot bullion. A positive “lease” rate has been the norm until recently, which simply means that the compensation for holding silver (to sell at some future date) was less than the compensation for holding (to lend) fiat money. In other words, if you were to borrow at LIBOR to buy silver in order to sell it forward, you’d lose money.

This changed around September of last year when the compensation for holding silver (represented by the forward rate) started to exceed the cost of borrowing fiat money (represented by LIBOR), especially for the 1-month, 2-month and 3-month maturities. The situation has remained the same for much of the past 11 months. Until today that is, when the LBMA forward rates across all maturity terms dove to less than 1%. Interestingly, the implied 1-year forward rate of the COMEX silver futures remains around 3% as I write this, which is not much changed from the recent past.

Before I discuss implications, I’d like to point out two things. One, the Kitco silver “lease” rate chart does not show correct data for last Friday according to the LBMA, so that plunge in their charts of the silver “lease” rate should be ignored. Second, last Friday’s huge drop in the price of silver no doubt had something to do with the spike in “lease” rates, but I should point out that there was no similar spike during silver’s bottom last August. Nor was there a similar spike in “lease” rates corresponding to other violent lows in the silver price during the past few years.

So, what does this mean? I’m going to pull a fast one here and let you figure it out for yourself. If you think you have the correct answer, please post it in the comments section. I’ll come back later to see if some guidance is necessary. When the subscription service gets going, the correct answer to posts like this will earn free subscription credits. For now, my primary intent is to torture and amuse (encouraging silver investors to think for themselves is just an afterthought). Hint: think basis.

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A Fabrication Bottleneck or Something More
James Turk
August 17, 2008

Mr. Turk makes some very good points here. He confirms my recent observation about the huge disconnect between retail and wholesale bullion. He points out that leverage in the paper market is primarily responsible for the bloodbath. He shows us log price charts that indicate gold and silver are very close to long-term trend support. He wonders if the lack of supply at the retail level, not only in the U.S., Canada and Europe but in India as well, portends a sharp V recovery in PM prices, especially after the U.S. elections in early November.

His best idea, however, is that the rise in premiums on retail bullion can be viewed as a form of backwardation, as can the lack of availability. I hadn’t really thought about it this way before but he is absolutely right. If there was a price chart for silver Eagles or 100 oz. bars, it would show a growing gap between the price of futures and the price of retail bullion products.

Bear with me here. Actually calculating this type of basis is a bit different from the one we can directly derive from the spot and futures markets. Spot silver or gold does not have a manufacturing or dealer premium (unless bought from a dealer of course). Retail gold and silver does. Typically that premium is expressed as spot + X cents or dollars. Another way to look at fabrication and dealer premiums would be as a percentage of the spot price. Both have their advantages and disadvantages when making historical comparisons. It might be possible, however, to somehow combine the two and establish what the average gap between futures and retail bullion prices has been over time. Or perhaps more simply, we can look at just the gap between retail bullion prices and spot prices.

If wholesale backwardation can be defined as spot (wholesale) bullion prices rising over futures prices, then perhaps retail backwardation can be defined as retail bullion premiums rising over their highest historical average (throwing out the extremes like 1979-80 and 1999). I haven’t completed even a back of the envelope calculation using either cent/dollar or percentage premiums, so I can’t say for sure that, according to such a definition, we are now in retail backwardation. But let’s remember that a key feature of backwardation is a tightness, even lack, of available physical supply at a given price. Isn’t that effectively what’s happening here with retail bullion?

I’ve decided to go back and look very carefully at my spot-futures basis data over the past few days to see if there are any signs of abnormality. There has indeed been a decrease in the contango (the basis has fallen toward backwardation but is still in contango) but frankly not as much as I would expect if there was robust physical demand in the spot market while COMEX and other paper markets were being aggressively sold. It is not at all unusual for the basis to contract and expand right before and during major price moves. We are certainly seeing that now. But there is no official backwardation (yet) in gold or silver. We could see some interesting developments in the days ahead, though. I will try to keep my eyes on this (and a bunch of other things).

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