After
rocketing 76% higher in just 5 months, silver continues to enthrall investors
and speculators. In the decade I've been gaming its bull through actively
trading silver stocks, I've never seen this metal so popular. As more traders
discover silver and start following and trading it, I've heard a lot of
questions on a recent development in the silver-futures market. Its open
interest recently declined sharply.
Specializing
in stock trading myself, I don't delve into the futures world very often. I
haven't written about silver futures since 2005.
Mostly this is because years of research, study, and trading experience have
shown me that silver futures usually aren't particularly relevant to
silver price action. Silver's primary driver is actually the price of
gold, so if you want to trade the silver complex successfully watching
gold is the key.
Not
only does silver-futures action fail to help me profitably trade silver
stocks, it has long been ground zero for conspiracy theorists. While not as
prevalent today, back in the early 2000s some newsletter writers made a
cottage industry out of promoting endless silver conspiracy theories. I
witnessed countless traders get bogged down in and derailed by this
contradictory and ever-changing mythology. The end result was often deep
paranoia that crowded out rationality, crippling their ability to profitably
trade silver.
The
modus operandi of the most-prolific silver conspiracy theorists was similar.
They spent endless hours analyzing and attempting to draw conclusions from an
arcane government report. Since this report is so technical and difficult for
laymen to understand, they acted like high priests ferreting out its secrets.
Their assertions started with facts from the report, but ended with opinions.
Their followers eagerly hung on every word, trying to expose the vast
conspiracy that prevented them from getting rich in silver overnight.
Published
every week by the US government's Commodity Futures Trading Commission, this
cryptic document is known as the Commitments of Traders report. Go download
one and see what a nightmare it is! There are currently over 60 different
versions of this one report published weekly, covering different futures
contracts and exchanges. Each futures contract has 10 to 14 columns of data spread
across 4 to 13 rows, depending on the format and what is included. They
definitely aren't easy to interpret.
To
an average individual investor who hasn't spent dozens of hours getting up to
speed on the CoT, it may as well be ancient Greek.
Adding to its mystique, prior to 1995 it was only available by paid
subscription. So newsletter writers would buy this arcane report that most
people didn't have access to, try to divine its mysteries, and formulate
seemingly highly-intellectual trading strategies based on it. And in truth, a
small fraction of futures traders probably really can use the CoT to help generate profitable trades.
Most
CoT analysis centers around one of three threads.
The first is open interest, or how many futures contracts for a particular
commodity are open and outstanding at a particular time. The second is the
distribution of these futures, how they are spread between three different
classes of traders. And last is concentration ratios, which reveal the
percentage of all open contracts held by some of the largest traders.
Open
interest is the easiest to analyze, and in silver's case is what is
concerning some investors and speculators today. It counts the total silver
contracts in existence. Each silver futures contract represents 5000 troy
ounces of silver. At $25 to $30 silver, this puts the notional value
of each contract at $125k to $150k. In order to control this much silver, a
futures trader only has to put up $6500 in margin money!
This
extreme leverage, along with the ability to directly trade commodities that
can't be traded in the stock markets, is the primary allure of the futures
markets to speculators. Controlling $125k worth of silver with just $6.5k in
capital represents leverage of 19 to 1. By law, margins for stock traders
can't exceed 2 to 1! This makes futures an extraordinarily high-risk
high-reward environment for traders running at the minimum margin. At $25
silver, a 5% move either way would either double their capital or wipe them
out!
Open
interest reveals how many silver contracts futures traders currently own.
When it falls dramatically, like it did in silver in November and December
after the CME Group raised silver-futures margins by 30%, traders get
nervous. Futures traders as a group are rightly considered more sophisticated
than stock traders as a group. So when futures traders start liquidating
positions rapidly, stock traders who pay attention to this stuff start to get
concerned. What do the futures guys know?
![](http://www.24hgold.com/24hpmdata/articles/2011/01/img/20110128els145.jpg) ![](../style/all/img/bouton/Zoom_in_6.png)
Silver-futures
open interest has actually been in a strong secular uptrend over the past
decade. In any secular bull, the longer a price powers higher the more
traders discover it and deploy their own capital to partake in the gains.
This uptrend has been remarkably consistent, with only a few extra-trend
episodes. Open interest shot up on big silver surges in late 2005 and early
2008. Nothing attracts in new traders like fast-rising prices hitting new
multi-decade highs, everyone wants to chase a winner.
But
those breakout surges didn't last, silver had soared too high too fast for
those levels to be sustainable. As soon as its near-parabolic uplegs collapsed, so did open interest. Silver is an
extraordinarily-volatile and unforgiving metal even without using leverage,
corrections of a third in less than 6 weeks are par for the
course. You can imagine how devastating a 30%+ plunge is for long futures
traders running 10+ to 1 leverage! Many are wiped out when silver corrects.
The
only time silver-futures open interest fell below trend was during the brutal
2008 stock panic. In addition to being driven by gold, silver is highly
sensitive to general-stock-market action. Between July and November 2008,
silver plummeted a jaw-dropping 53.4% before bottoming on the very day
the S&P 500 did! Again this obliterated leveraged silver longs and
reduced the survivors' appetite for risky silver futures for a spell.
But
as silver rapidly recovered after the stock panic, so did traders' desire to
own silver futures. Their open interest was back within the old secular
uptrend by late 2009. In 2010 they were flat for most of the year until
silver started rocketing higher in its massive autumn rally. But
interestingly there was no upside breakout in open interest this time, unlike
in the last major silver uplegs it merely edged up
to resistance.
I
remember some CoT watchers being concerned about
this in November. At silver's latest peak, only about 159k contracts were
outstanding. This compares to a staggering 189k in February 2008 and a
comparable 150k in November 2005. Was something wrong with silver last autumn
since fewer bets were being placed on it by the futures guys? Not so you'd
notice, as silver continued powering to new 30-year highs for 2 months
after the recent open-interest peak.
November
2010's lower open-interest peak never seemed like a big deal to me. It was
right up near secular resistance, silver-futures
trading is still growing on balance as this silver bull matures. If the peak
had happened well below support maybe that would be worth some anxiety, but a
resistance approach in a strong uptrend is very healthy and bullish. More
interestingly, consider the big expansion in notional value that each
contract represents as silver powers to new bull highs.
Each
silver contract has represented 5000 ounces throughout this metal's entire
bull. So a contract at the November 2005 open-interest peak when silver
traded under $8 was worth far less than one in November 2010 when silver
approached $25. To adjust for this, I labeled the last four major
open-interest peaks with the total notional value based on the silver price
and contracts outstanding. Even though one could argue open interest has
largely been consolidating since 2005, far more capital is involved today.
Back
in November 2005, the notional value of silver futures outstanding ran about
$5.8b. And 5 years later in November 2010, roughly the same open
interest represented a vastly-larger $19.7b worth of silver. So despite open
interest being more or less flat between these peaks, futures traders are playing
with about 3.4x more capital today. Notional capital is really important to
consider in a secular bull market, not just raw open interest with no regard for how much each contract is worth.
Another
interesting aside is the wildly-popular physical-silver ETF, SLV, was
launched in April 2006. I just wrote a new essay
on this silver behemoth a couple weeks ago. Since SLV gave stock traders
their first-ever way to bet directly (including through options) on
silver prices, there is a good chance that some capital that would
have been run through silver futures has been diverted into SLV. I wouldn't
read too much into this though, as SLV does not have the extreme leverage
that makes futures attractive to many.
And
this brings us to the impetus for this essay, the large 18.0% plunge in
silver-futures open interest between November 2nd and December 14th. Is this
worth worrying about? I don't think so. Note above that despite this retreat,
which was partially driven by the margin increase on November 9th, open
interest remained well within its secular uptrend. We've seen this metric
fall sharply from resistance to support many times in this bull, yet silver
still continued marching higher on balance. This latest swoon was merely a
garden-variety liquidation of silver futures, nothing special at all.
In
addition to reporting open interest on a weekly basis, the CoT divides futures traders into three classes.
Commercial hedgers are the main one, these are entities that are
theoretically actually producing or consuming the underlying commodity a
futures contract represents. Think of a silver miner that needs to lock in
its silver selling price in the futures market in order to secure a bank loan,
or a factory that needs to guarantee its silver purchasing price to control
its input costs.
The
remaining two classes are speculators, who are not actually producing or
consuming but merely want to bet on price action to earn a buck. They are
subdivided into large speculators, traders with big-enough positions that
they have to report them to the CFTC, and small speculators who don't have to
report. The most popular thread of CoT analysis
examines the aggregate bet each of these groups is making.
Every
individual futures contract has a long side and a short side. The long party
bets a price will rise while the short party simultaneously bets the same
price will fall. Thus the total number of longs and shorts is always
perfectly equal. Futures are a pure zero-sum game, every dollar
one side of a futures contract wins is a direct dollar lost from the
counterparty on the other side. But within the three classes of traders,
aggregate net-long and net-short positions develop.
![](http://www.24hgold.com/24hpmdata/articles/2011/01/img/20110128els146.jpg) ![](../style/all/img/bouton/Zoom_in_6.png)
In
a secular bull, it makes perfect sense for speculators to generally be net
long while commercial hedgers are generally net short. When a price rises on
balance for years, and its global supply-and-demand fundamentals remain
bullish, speculators bet that this bull run will persist. Meanwhile hedgers,
primarily silver producers, like to lock in their selling prices to protect
their cashflow streams from silver's incredible
natural volatility. The classes' positions above relative to the flat line
are totally normal.
But
it is provocative that since late 2004 the net bias of each class has been
relentlessly shrinking. Even though open interest is rising, more
silver futures contracts are being purchased, the directionality of bets
within each class is less coherent and one-sided. More speculators are taking
the short side of trades, gaming silver's brutal corrections. And more
hedgers are taking the long side, probably mainly the industrial silver
consumers.
Nevertheless,
just like in open interest the rapidly-rising notional value of each silver
contract must be considered here. When large speculators' net-long contracts
peaked in December 2004, they represented about $2.8b worth of silver. Yet by
September 2010, despite a much-smaller net-long position in this class, its
notional value had soared by 2.3x to $6.4b. The same
is true for small speculators. Despite shrinking net positions, the capital
speculating on silver futures is really growing.
Hedgers'
net shorts have seen a similar phenomenon. Though their net-short balance has
been shrinking, it has still nearly doubled from $3.6b worth of silver in
late 2004 to $7.0b last autumn. I wonder if SLV's launch led to more hedgers
(consumers) taking long positions in silver futures. Silver's industrial
users lobbied the SEC aggressively to deny SLV approval, because they feared
the flood of capital into silver would drive up its price. They were right.
So industrial users have likely been increasingly locking in their silver
purchasing prices by buying long futures. This would reduce hedger net
shorts.
While
the class distribution of silver futures is interesting, after watching it
every week for a decade I really don't think it is particularly useful. As a
zero-sum game, every single short has an offsetting long and vice versa. So
when commercials got to record net shorts, which used to drive conspiracy
theorists into a rage, it also meant speculators grew to record net longs.
Each silver contract is matched and neutral, so the notorious shorting
boogeymen can't add shorts unless other traders
voluntarily buy offsetting longs.
In
addition, the class lines are blurry and arbitrary. A silver-futures trader
like a miner or small investor clearly falls into its appropriate class. But
what about an aggregator like a major bank that has
many different clients? If its futures are held in the bank's street name,
should it be classified as a hedger or large speculator? What if 60% of the
futures trades it has on are for mining clients and 20% for hedge funds one
quarter, but the opposite the next? How is this bank classified? The more I
learn about the CoT, the less I trust the way its
classes are drawn.
This
same problem, how to classify traders that aggregate their own clients'
trades, is the primary reason the third thread of CoT
research is also pretty pointless. Concentration ratios reveal what
percentage of open interest (long and short) is currently held by the largest
4 and 8 traders. For an entire decade, conspiracy theorists have been going
apoplectic screaming about how these ratios must prove their
manipulation mythologies. Zero-sum game be damned!
But
concentration is meaningless if large single traders are aggregators. If a
bank trades futures for 1000 clients, but that bank is counted as a single
trader because it holds its clients' futures in its street name, is its
attribution as a large trader really meaningful? I certainly don't think so.
And when you look at long-term charts of concentration ratios in silver
futures and other commodities, they really don't change a great deal. Large
traders will always hold a large fraction of outstanding futures, no
surprise. Futures have always been the realm of the big sophisticated
players, not small traders.
So
personally, I don't find the CoT very useful for
trading silver. The flowing and ebbing of the various numbers it reports
don't consistently correlate with silver uplegs
and corrections, so it isn't very useful for timing silver's major moves. And
since it is only published once a week, and delayed, it doesn't offer a
high-resolution real-time read on the state of silver futures. This is a
government report that's been around in one form or another since 1924, most
of its conventions are from a bygone era and don't adequately reflect modern
global markets.
While
I do realize some traders are able to mine the CoT
for useful data, it hasn't helped me despite many years of studying it. The CoT reflects reactions to silver-price moves
sparked by other drivers, primarily gold and the general stock markets, not causes.
And if any particular information set doesn't help time entries and exits
that lead to profitable trades, it is no more than peripheral trivia for
investors and speculators. Our finite time is better used in studying the
real primary drivers of prices like silver.
And
I can't even count the number of investors and speculators I have heard from
in the last decade who got all hung up over the CoT
due to some nonsense-du-jour some wacky conspiracy theorist was babbling
about. This report is misused and abused constantly. So unless you
find someone with a public, proven, and profitable track record trading
silver futures based on their analysis of the CoT,
I would be very wary of putting too much faith in it. It's a minefield that
seems to confuse more than enlighten.
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The
bottom line is nothing looks strange in silver futures per the Commitments of
Traders report. Open interest has declined, but it remains well within its
secular uptrend. And the rising silver price has multiplied the notional
value of silver traded in the futures market, despite open interest failing
to make new highs last autumn. The net positions of the trader classes are
shrinking too, but this trend has been in place for over 6 years now (since
silver was around $8). It's nothing new.
While
silver futures will always be an important part of the silver market, traders
have to remember they are a zero-sum game. Every short has an offsetting
long, and vice versa. It's easy to get bogged down and derailed in the CoT, giving this report more credit than it deserves. Its
trader classes aren't accurate and it doesn't consistently signal major
interim highs and lows in silver. It's more of a curiosity than a tool.
Adam Hamilton,
CPA
Zealllc.com
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comments, or flames? Fire away at zelotes@zealllc.com.
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- 2006 Zeal Research (www.ZealLLC.com)
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