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Take it to the Limit

By Theodore Butler

(The following essay was written by silver analyst Theodore Butler. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

A friend of mine, Eric King, called yesterday asking whether I thought silver could trade at limit up for a number of days. After the conversation was finished, he suggested I write about what I told him, as he was certain that most silver investors, and even most silver futures traders, were unaware of what I thought was common knowledge. After thinking about it for a moment, I agreed that most were probably unaware of what the real limit situation was at the COMEX, for silver (and gold.)

First, some background. Limits are the maximum daily price change, up or down, from the previous day’s closing settlement price on all commodity futures contracts. (There are no daily price limits on options on futures contracts.) The reason for these daily price limits are twofold. One, they allow for a cooling off period of a day (a “time out” of sorts), in the event of some unexpected market-jolting news. (The announcement of the Mad Cow discovery and the subsequent limit downs in the cattle markets are a timely example.) Limits give everyone 24 hours to think things over and assess the news with less emotion. Two, because futures are traded with very little money down, limits allow more time for those who need to raise money suddenly for margin calls for being on the wrong side of big price move. This strengthens the clearing, or guaranteeing, feature of the futures trading system. Both reasons for having limits are good, and they have generally stood the test of time.

The only negative to having daily price limits, at all, is that, by definition, they restrict free trade and eliminate liquidity, albeit only temporarily. The whole purpose of having limits is to preserve the integrity of the markets by restricting unnecessary and shocking price volatility that would damage the very workings of the markets. Therefore, it is the aim of the licensed exchanges and the government regulator, the CFTC, to strike the proper balance between having too small, or tight, a limit that would be triggered too frequently by normal price volatility, and having daily price limits set so large, as to be ineffective to the goals of cooling things off and allowing more time to raise margin money. Certainly, no exchange or government official has ever come forward proposing that daily price limits be eliminated completely, to my knowledge.

That’s why most people are surprised when they learn what the daily price limits are in COMEX gold and silver. Ask most traders and investors what the daily price limits are and they’ll respond, “something like 75 cents/per ounce in silver and around $25 dollars in gold”, as these used to be the limits many years ago. But that is definitely the wrong answer. Effectively, there are no daily limits in gold and silver. No cooling off period. No additional time for margin money to be raised. Don’t believe me? Here is the exact wording, copied from the NYMEX web site for silver (for gold, just substitute $75 per ounce for the initial limit) –

Maximum Daily Price Fluctuation
Initial price limit, based upon the preceding day’s settlement price, is $1.50. Two minutes after either of the two most active months trades at the limit, trades in all months of futures and options will cease for a 15-minute period. Trading will also cease if either of the two active months is bid at the upper limit or offered at the lower limit for two minutes without trading. Trading will not cease if the limit is reached during the final 20 minutes of a day’s trading. If the limit is reached during the final half hour of trading, trading will resume no later than 10 minutes before the normal closing time. When trading resumes after a cessation of trading, the price limits will be expanded by increments of 100%.
A fair reading of what the daily limit is in COMEX gold and silver would be no limit. That’s because the limit is only temporary and expands throughout the day. This arrangement is tantamount to having no daily price limit. Consequently, there are no real daily price limits on COMEX silver, the commodity with the largest naked short position in the history of the world. According to the NYMEX/COMEX’s own rules, the price of silver could jump $10 or $20 per ounce, or more on any given day. (At current prices, silver can’t possibly fall that amount). Come to think of it, this “no limit” limit fits in perfectly with the “no limit” speculative position limit that the COMEX and CFTC permits in silver. Who thinks up these idiotic rules? Why not just say, no limits? Why hide behind a misleading formula?

I can assure you that I don’t have to think very hard to uncover examples of the absurd governance of, and wrongdoing on the COMEX silver market. This one came out of a conversation with a friend. This stupid and fraudulent daily price limit formula was put into effect 10 years or so ago. Most people are unaware of it because it has never been stress-tested. The first day it is stress-tested will also be the last day it probably exists, in my opinion. That’s because it is not a legitimate limit. I’d love to hear the COMEX and CFTC try to defend it, but we all know they can’t defend any issue I raise. So be it. But make no mistake – this is just another example of what’s wrong on the COMEX.

This absurd and stupid daily price limit formula has gone undetected by most people because the silver price has been manipulated for so long and has been kept in such a narrow and depressed price band, that any daily limit would never have been hit. That’s how effective the silver manipulation has been – most current participants have never even seen a limit move in the silver market. But, take my word for it – that’s about to change.

The bottom line on this discussion is not to get the COMEX to institute valid daily price limits, like all the other exchanges. At this point I don’t think it really matters, and it does get tiring to keep offering constructive solutions to obvious problems and have the regulators just look the other way. The purpose of this article is to show, once again, how poor is the governance of the NYMEX and the CFTC, and how the very rules they have adopted are nonsensical.

Think about this – here we have a commodity with the largest short position ever witnessed, with no daily price limits, and all that is required to sell a contract short is margin of 27 cents per ounce ($1350 per 5000 ounce contract). If silver were to move $5 in one day, like it has in the past and could in the future, and is permitted by the moronic COMEX daily limit, a short speculator would have to immediately come up with $25,000 for every contract held short. Or almost 20 times the total margin of the day before. Immediately. It’s totally irresponsible for an exchange to permit such a possibility and suicidal for the short speculator himself. Who runs this exchange anyway?

Perversely, the poor governance and structure of the COMEX points to what a great buy real silver is. Only such a messed-up market structure could and would have tolerated such a long term manipulation. While it’s a shame that the people at the NYMEX and CFTC are doing such a poor job regulating the silver market, they are also presenting you with the gift of mispriced silver. It would be wrong not to accept that gift.

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