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Some alternative silver investments offer even more
leverage than mining shares, according to expert David Morgan. In the fifth
and final chapter of our "Guide to Silver Investing,"
David discusses the risk, reward and reality of futures and other alternative
investments. Read on. . .
Leveraged Silver Investments
As if mining stocks did not provide enough leverage,
there are still other avenues that offer even more leverage than mining
shares. The decision to use leverage in a precious metals purchase is a
decision to accept a greater percentage of risk relative to your capital
outlay.
The potential is for an increased opportunity to
earn a greater percentage of profit. The use of leverage should match your
risk ability, both from a financial and psychological point of view. The
increased risk in using leverage is not worth it for most people.
It is my opinion that more damage has been done to
the precious metals markets, and in particular silver, by the use of leverage
than any other factor. This statement cannot be proven and again, is opinion;
however, let us look at a typical scenario that has been repeated thousand upon thousands of times over the past quarter
century.
A novice will do some preliminary research or
reading and discover that silver has a supply-demand relationship that is
very favorable. Using this "knowledge," silver seems like a
"no-brainer" and this eager novice decides to use all the leverage
available.
This fledgling investor opens a futures account,
puts in the minimum margin required by the broker, goes "long" or
buys silver on margin and, within a very short time, is wiped out. At that
point this novice does not take personal responsibility for the loss, but
instead blames someone or something else.
The tragedy is that this potential silver investor
usually gets a bad taste for silver and will not ever enter the silver market
again, but also joins the bearish camp in many instances.
Some of these people frequent Internet chat rooms
and extol their "knowledge" about why silver is a poor performer.
First, you must remember that paper silver does not
equal real silver. That is, all silver derivates— whether stocks,
options, futures, leverage purchases, pool accounts or exchange traded
funds—are derived from the asset silver, but the real silver backing
the transaction is not available for settlement. This is an important
point—you may buy into some type of investment that is silver "backed,"
but by contract all you can receive is paper settlement, in other words, a
check.
Consider all of the silver futures traders that have
lost money over the past 20 years and you start to comprehend how differently
the silver market price dynamics might have been if silver were a cash market
only. This means no futures trading, but simply a cash-and-carry activity
where investors and fabricators alike would buy silver at the current market
price, which would vary due to the physical supply and the actual demand.
Before the reader asserts that a futures market must
exist in all commodities, let us suggest for your consideration that eggs,
potatoes and milk used to have futures markets but don't any longer. All of
those commodities still exist and the price-setting mechanism is still
intact.
Sources of Leverage
Futures
Futures brokers are licensed brokers with the
Commodity Futures Trading Commission (CFTC), who deal on exchanges, such as
the New York Commodity Exchange, Chicago Board of Trade and other areas.
Acting as agents, using an open outcry system, the price for a given
commodity is established. Purchasing silver from a futures broker requires
that the individual put up a good-faith deposit. This deposit assures the
broker that the investor will meet the contractual requirements.
Leveraged Dealers
Leveraged dealers are authorized to offer investors
the ability to buy and sell precious metals on a margin basis. The agreement
between a leveraged dealer and a customer is a legal contract. Transactions
are conducted on the basis of this contract.
Leveraged dealers are the principals in all
transactions and establish the bid and asked prices on a variety of precious
metals investments. Leveraged dealers maintain the ability to meet their
obligations to their customers with physical inventories, futures contracts
and at times swaps and forward positions.
A leveraged contract allows the purchaser to take
delivery upon full payment of the balance due. This is very close to a
futures contract. The leveraged contract evolved during the late 1960s in
response to the growth of investor interest in United States of America
silver coins. Coin dealers began to sell bags of U.S. coins to the public on
a cash basis. The maximum a purchaser could lose was the difference between the
face value of the coins and the value of the silver content of the coins.
Customers began to finance coin purchases pledging the coins as security for
the loan. This method of leverage became very popular during the previous
bull market in precious metals.
Leverage Has a Price
The bottom line is when you purchase precious metals
with leverage you are using credit. All forms of credit subject you to
interest charges. In a futures contract, the outgoing months are priced
higher based upon the current cash price plus the going short-term interest
rate. This cost is referred to as the "contango"
or the "carrying charge." Each month into the future becomes more
expensive on an incremental basis.
Generally, futures trading is
done on a lower commission charge than banks or leveraged dealers. There are
exceptions to this general rule, however. In an inflationary environment, the
monetary unit in question loses value; this permits a borrower to pay down
the loan with less valuable units of exchange. So, in an inflationary
condition, borrowing to purchase precious metals seems to make sense.
However, because the price movement is amplified to
the investor both up and down, many investors have learned the hard way that
leverage is not always a smart decision. Unfortunately, most folks use too
much leverage, do not have a plan in place if the market moves against their
original purchase order, and do not have sufficient capital to be in a
leveraged condition to begin with.
If the metals market moves to such an extent that
the investor no longer has sufficient equity, then the purchaser (borrower)
is subject to a "call" for additional funds. If a margin call is
made, the investor is required to send funds within a very short timeframe.
If funds are not received within the period specified, all or a portion of
the account is liquidated to satisfy the investor's contractual obligations.
This can be a very discouraging situation and would not happen if the
investor had chosen either to make a cash purchase, or used a suitable amount
of leverage relative to the investor's capitalization.
Whether one should meet a margin call or liquidate a
position is a personal choice. Many differing attitudes exist, ranging from
never meeting a margin call (cut your loss) to making additional purchases
(averaging on the way down). Whatever the individual choice, you must be
prepared to take the appropriate action.
It is best to bear in mind that most who enter into futures end up losing money. The
professionals are very good in their abilities to trade the markets and most
individuals are not. Being free-market oriented is certainly a personal
choice whether you choose to use leverage, and we support your decision. But
be prepared because all markets go up and down and you could be correct about
the overall trend and still lose money on a short-term move against the
primary trend.
David
Morgan
The Morgan Report
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