The silver market has been remarkably quiet in the wake of China’s destruction of the gold market. This week, we’ll touch on a couple aspects, specific to silver that show while commercial traders have been buying this decline, it may be prudent to wait a bit longer before stepping in. Normally, I take a bottom up approach to putting these pieces together beginning with macro issues and finishing with trade details. This week, we’ll set the stage and then move from myopically focusing on the current setup before discussing the potential dangers of this viewpoint.
China unleashed a torrent of selling in the gold market in response to the Trillions recently lost in the Chinese equity markets. According to Reuters, China sold as much as 33 tonnes of gold worth more than $1.3 Billion Dollars in the first two minutes of trading on the Chicago Mercantile Exchange’s (CME) Globex platform. The selling was so hot and heavy that CME circuit breakers tripped twice within the first minute of trading. This pushed the gold market to its lowest levels since March of 2010 and pushed gold’s option volatility up by more than 25%!
The gold move has happened. Trading is always about what will happen. This is where we go to our trusty Commitment of Traders screen to examine the market’s internals to determine if the smart money sees these prices as cheap or dear compared to their forward estimates. We discussed the relative value commercial traders were seeing in the silver market for TraderPlanet earlier this month and according to our typical screen, this view would only strengthen.
As you can see in the chart, all three of our puzzle pieces fit together in a, “Buy” format. Commercial traders are bullish. The market is oversold in the short-term. Some type of reversal higher is all that would be needed to trigger a trade from the long side of the market. Furthermore, considering the success of the recent COTSignals in the silver futures, confidence in taking the trade would normally be high. However, stepping back to the long-term chart provides a much clearer picture of where we stand contextually.
The big picture creates some compelling story lines. The commercial traders typically take their biggest positions ahead of the market’s biggest moves. We can argue all day about cause and effect but the correlation is quantifiable. There are a few points to be made here. First of all, we’ve discussed the inherent quirks of the commercial traders in certain markets and specifically, the quirks of the commercial silver traders. Most notably is that over the last 20 years, commercial traders have NEVER been net long. The point here is that this market is dominated by silver producers’ forward hedging rather than silver’s end, long hedger users.
Currently, the commercial net position is short approximately 15,500 contracts. Commercial traders have recently topped out at net short 10,000 – 15,000 contracts several times over the last year. Furthermore, their record bullish position is net short just over 4,000 contracts. Taking a look at the big picture shows commercial traders nearing their bullish exhaustion level.
Here comes the scary part. The commercial traders’ position has grown disproportionately to the other markets participants. Just a couple of weeks ago, commercial traders controlled more than 62% of the silver market’s total open interest. We discussed the short trap possibility in our feature for TraderPlanet on July 6th, “Silver Primed for Short Covering Rally.” Clearly we’ve been wrong this trade but fortunately, we have a handful or two of contracts to move. Therefore, no liquidity issues. The commercial traders on the other hand, may throw in the towel on these long positions. In which case, the fall could be dramatic. We’ve seen the commercial traders move 40,000 to 50,000 contracts over a couple month period quite regularly over the last few years including 25,000 in a week as recently as late May.
The sum of these pieces and parts will keep me on the sideline in spite of the current, nearly completed long entry setup. Based on the range of commercial trader behavior in the silver futures over the last 20 years, we simply see them as having far more selling capacity than buying capacity left in their arsenal. That being said, we can’t actually take a trade in the opposite direction of our research thesis – trade with the commercials. In our world, it’s akin to, “Don’t fight the Fed.”
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