Apocalypse Revisited: Silver Market Update

by Joshua Enomoto, Founder of ContangoDown.com and FutureMoneyTrends.com contributor

With spot-silver down below the all-important $30 mark again, many market participants are understandably frustrated: if the fundamentals are so bullish, like so many experts and gurus emphasize, then why the %&$# are the precious metals taking a beating!? Usually, the answer proposed by the alternative investment community is “manipulation by the Rothschild cabal” or “irrational market behavior.” While I am neither a conspiracy theorist nor a psychologist, I will offer three points:

  1. There are irregularities in the silver sector
  2. Similar irregularities have occurred in the past
  3. The long-term market (+8 months) is more bullish than bearish

First, let’s acknowledge the irregularities in silver by examining its derivative market, popularly known as the “options chain” of iShares Silver Trust, or SLV. Options are contracts that give the owner the right, but not the obligation, to purchase (call option) or to sell (put option) an underlying market entity at a specific price within a specified period of time (Murphy, John J ; author of Technical Analysis of the Financial Markets). Options in and of themselves have no intrinsic value but rather derive value from an underlying asset, hence the name “derivative.” In most cases, the options fluctuate in value according to the market action of the underlying asset, but options are traded within its own market sector. Both fundamental and technical analysts examine the put/call ratio (which is a ratio of put volume divided by call volume) to determine market sentiment. A high put/call ratio suggests bearish sentiment, as volume is more heavily focused on the trading of puts (where the owner of the put makes profits from an underlying asset moving downwards in price). However, an excessively high put/call ratio can often be used as a contrarian indicator, where market sentiment has gone too bearish and that a bullish reversal is likely.

For the chart below, I have plotted the put/call ratio for SLV options with expiration dates in March through January (2014). Within the same chart, a similar ratio was plotted for open interest, or options that are not closed or delivered within a particular trading session.

As expected, March options are indicating bearish sentiment, as the put/call ratio is 1.3, meaning there are 1.3x as many puts traded as there are calls. In the near-term, it is very possible to see silver challenge horizontal support at $28 and even $26. However, we also have to keep in mind that overall, the put/call ratio is about 0.5 or less, meaning that call volume is usually twice as much as put volume in future contract months.

The one glaring exception is options that expire in October 2013. Here, the put/call ratio is 2.42, dwarfing the ratios registered in other contract months. This is a major irregularity in the silver market as bearish open interest does not rise in accordance with the volume. Specifically, what is causing the ratio rise is put options with a strike price of $26 (which equates to roughly $27 in the spot-market), where volume is 3,019, over 5 times higher than the next most dense put. In fact, the volume exceeds open interest by over 270%, suggesting massive activity. As it is highly unusual for volume to exceed open interest, especially by such a large margin, an investor can reasonably speculate that the October options activity is a contrarian indicator.

For a look at how a “normal” options market operates, let’s consider Carnival Cruise Line, or ticker symbol CCL:

To no one’s surprise given the recent black-eye that Carnival gave to the cruise line industry, bearish activity increased for March options. This is evidenced by both a high put-to-call ratio, as well as a high open interest for puts relative to calls. However, both the volume and the open interest ratios decline the further out the contract months are spread, confirming the normalcy bias of stock market psychology: over time, stocks tend to increase in value. Also, despite the current bearishness, CCL is in a comparatively healthy industry. It is very difficult to beat the “fun per dollar” basis that the cruise industry offers, and therefore, the above chart is indicative of short-term setbacks but long-term growth.

Unlike CCL, silver bullion’s price actions at times betray its fundamentals and this discrepancy is most noticeable when analyzing palladium. As an element, palladium is imbued with unique properties that make it indispensable for operating our sophisticated society. In fact, developments in advanced sectors such as fuel cell technology would be impossible without this element. This makes it similar to silver in that many of our technologies that we take for granted would not come to fruition were it not for precious metals. The key difference, though, is palladium’s usage is centered on industrial or commercial demand, with a majority share allocated towards the automotive sector as a critical component of catalytic converters. Investment demand, while not unheard of, is currently nowhere near the popularity of gold and silver bullion.

This has the advantage of making palladium’s market action easier to predict: as the automotive industry goes, so goes palladium. Most of the time, there is a strong correlation between spot-palladium and the Dow Jones Transportation Average; therefore, with the transportation index hitting all-time highs, it’s no wonder that palladium is the least affected in the recent downturn of the precious metals sector. However, silver also plays an important part in the automotive sector, with 36 million ounces appropriated for this industry. While that only represents 4 ~ 5% of annual mining production, your car simply wouldn’t function without silver. Also, with investment demand heavily leaning towards bullishness, as evidenced by the SLV options chain, spot-silver should be moving up, or at the very least, sideways.

So what gives? To provide a possible answer, let’s consider the 3-year daily chart of the Dow Jones Transportation Average interposed with the price action of spot-palladium and spot-silver:

While the connection is rarely (if ever) made, there is a recognizable measure of correlation amongst silver, palladium, and the Dow Transportation index. The two precious metals are even more tightly correlated, with one notable exception: there are times when palladium rose and shared an inverse relationship towards silver, as occurred in April 2010 and January 2011. Both times, silver dramatically increased and it remains to be seen whether it will do so again. Palladium is currently trading at $754/oz, roughly 5% above its one-year high. Silver is trading at $29.80, 20% below its one-year high.

Personally, I believe that silver will rise from its current price point but that it is unlikely that we will see a new nominal record being set within the first half of this year. In the immediate time frame, we have to acknowledge the rise of bearish volume in the options market and that could create some “funny business” for the next few weeks. However, whether we are looking at derivatives or the real deal, the overriding sentiment is bullish; therefore, I don’t think this is the time to dump the metals.

Also, I would not want to initiate puts and hope for prices to fall to $19/oz as the derivatives market is not bearish enough for an investor to feel confident that his” hopes in reverse” will pan out favorably. While the Commitment of Traders report suggest that commercial shorts are steadily increasing, so are commercial and non-commercial long positions, and quite dramatically at that.

Clearly, smart money and the insiders are moving into the silver market, and not all of that volume is on the short-side. Therefore, consider the current dynamics in context before making rash decisions in the precious metals sector.

One thought on “Apocalypse Revisited: Silver Market Update

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