March 7, 2011
Silver: Short Squeeze or Bust?
By Brady Willett
As if continued backwardation were not enough, tangible evidence has surfaced that there is a widespread shortage of silver. Apparently responding on cue, this shortage has led to an increase in speculative demand for silver and the recent accumulation of short positions by the ‘evil’ shorts (i.e. J.P. Morgan). A break significantly higher could lay the shorts to waste and cause one of the most profound squeezes in history. Conversely, any minor correction in silver could snowball into a repeat of the 2008 massacre. What can be assured is that a period of peaceful consolidation around current prices is unlikely to happen.
With the intention of putting some skin on the ‘bust’ scenario, I recently purchased HZD (Toronto). On Friday this position lost more than 7% in the session. I am so ecstatic about this loss that I am thinking about purchasing some more. Allow me to explain:
I own a small position in HZD because I did not want to sell my silver. This was the right hedge for me, but it may not be the right option for you.
‘Hedges’ are essentially an educated and timely gamble on a major price move against your primary position. However, please do remember that hedges lose their purpose if they become the primary position. Although considered sacrilege to some bugs, hedging your precious metals holdings can help you avoid the mental anguish that arrives when you consider selling your beautiful gold/silver.
As for the question at hand: squeeze or bust? My best answer would be a mini-bust soon and historic squeeze later. The world is not ready to abandon the dollar - the currency of choice for the ‘evil’ shorts...
Some Speculative notes on hedging
Keeping in mind spreads, commissions, margin levels, etc., the best way to hedge precious metals is through the diligent use of futures and options contracts. However, for the vast majority of investors ETFs are more easily owned and can serve a similar purpose. You can also get leverage in many ETFs, and if you trade the derivatives on these products you can acquire leverage on leverage. Please note: with leveraged ETFs it is important to fully understand the natural price decay that occurs as contracts rollover and/or the timely nature of your hedge.
Below is some very basic (and soon to be very dated) math using ZSL options as the hedging vehicle. The math below takes a look at the April 39 calls (@$0.20 per contract) and the August 40 calls (@$1.25 per contract). In order for these calls to be in the money silver would need to correct by 20+% (assuming ZSL performs as expected, which is probably won’t).
 |
The basic idea behind the above is that an options position that takes away cents per ounce from actual silver holdings, can play a big role during major price correction. For example, although a repeat of 2008 is probably not in the cards, it would take less than $400 to fully protect a $10,000 silver position from a 57% decimation (in grey). 4% may be too high a price to pay for downside protection, but the logic of enacting/sustaining a 1%-2% derivatives hedge against your silver is nonetheless worth entertaining.