Silver experienced another amazing week, advancing from 42.155 to 45.175 on the week (and up another $1.5 in Asian trading at the time of this writing). Even more impressive than the gain in silver has been the volume behind the advance. The below chart shows the price of silver, with the aggregate volume on silver futures contracts below the chart.
As can be seen, volume on silver futures has exploded with the recent price gains in silver, a very bullish technical sign. Usually, when volume on a security increases with a significant move in price, the conviction behind the move is thought to be strong because of how many people are participating. Conversely, when market participants view a large move in a security with falling volume, it is a sign of an imminent reversal.
The average volume on silver futures has increased from 73k contracts on April 1st to 117k contracts as of April 21st. This is an absolutely huge increase. The average volume on silver futures has increased 59.7% in the same time span that silver itself has increased 22.22%. The amazing increase in breadth behind this move is truly striking, and indicates the strong likelihood of further gains. However, even more amazing is the lack of participation of Managed Money (hedge funds, commodity funds, pension funds, etc.) in silver’s recent strength.
This Week’s Commitment of Traders Report
The below chart shows silver’s price in gray and Managed Money net longs in green.
As can be seen, Managed Money has cut its net long position by 13.34% in the same time span that silver itself has rallied 22%. This indicates that silver is actually rallying in spite of futures speculators, not because of them.
In fact, Managed Money short positions in silver are actually quite high. The below chart shows total Managed Money shorts since January 2009.
It appears that the number of traders trying to “call a top” in the silver market is growing very quickly. As can be seen, the number of Managed Money short contracts has more than doubled since the end of March. This type of action is exactly what a silver bull wants to see, silver prices climbing in the face of greatly increased short selling pressure. As these short sellers are forced to cover, the price of silver will only go higher.
The lack of participation by Managed Money continues to perplex us, as we believed Managed Money would come around and join the uptrend much sooner. However, as we have stated recently, the buying pressure of physical and ETF buyers of silver has greatly outweighed any skittishness on the part of Managed Money.
The below chart shows price and volume on the SLV.
As can be seen, volume on the SLV has increased greatly in the past 2 weeks as silver has started to soar yet again. Even with the SLV almost 22% above its 50 day moving average, the breadth of the silver rally has been astounding.
As we mentioned last week, the increase in silver holdings by physical buyers and the ETFs is a massively bullish development for the silver market. So-called “retail” participants favor the SLV and silver coins to silver futures because of their relative ease and familiarity. In most financial markets, increased participation of retail investors is a death signal to a large rally, as small mom and pop investors are the last to get in. However, in silver’s case, the hoarding of silver by physical and ETF buyers takes the metal out of world supply, further constricting supply tightness for investment demand, and thereby boosting prices. As more and more silver comes out of supply, the amount left for industrial demand and absolutely booming investment demand is decreased, and a physical shortage commences.
The other reason to be bullish about greater retail participation in silver is that retail investors are by and large not leveraged. Although it is possible to buy the SLV on margin, the leverage afforded even the most daring margin investor is nothing compared to the futures market. The physical silver market obviously has no ability to leverage, as silver dealers accept only cash for coins/bullion. Since the greatest participants in the silver market currently (physical and ETF holders) are implementing their position with very little to no leverage, they will not be forced to liquidate even if prices correct severely. This type of staying power should prove supportive if and when silver pulls back.
While Managed Money has stood mostly on the sidelines, if and when Managed Money decides to increase net longs, look out. Silver may increase by another $10-20/oz in a matter of weeks or even days.
With the huge amount that the silver market has rallied recently, silver could easily experience a correction down to the 50 day moving average or below. Considering the 50 day moving average for silver is almost $10 below where silver futures currently trade, that would be a $50,000 loss per contract for a futures traders (hardly a small loss). On the other hand, silver market internals all look wildly bullish, so a bullish strategy with less downside than an outright long position seems to be prudent.
We recommend purchasing the July 50 calls on silver for $1.616, or $8,080 per contract. The maximum loss on this trade would be the amount paid for the option, while the potential gain is unlimited. The trade would be profitable upon expiration (June 27) if silver is trading above 51.616. Since increased Managed Money participation as well as short covering by those looking to pick a top in the silver market could vault silver much higher, we believe the risk/reward ratio of this trade is highly attractive.
Given the silver market’s volatility and the chance that it could correct violently, traders should be also be ready to capitalize on any correction. An example would be to sell the December 30 put on silver if prices correct severely. While the $30/ounce level is high on a historical basis, we view it as an attractive entry point if an investor has the capability to hold silver over the next 2-3 years. If silver undergoes a correction, selling this type of protection should be a profitable trade, as nervous investors will pay handsome premiums to buy protection. With implied volatility on the December 30 put currently at a very high level of 48.6%, investors will be willing to pay dearly for put protection if silver experiences any headwinds.
If desiring to effect these same trades through the SLV, an investor could buy the July 50 calls on the SLV for $2. On a correction, the January 2012 30 puts could be sold.
ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.