In Ted Butler's Archive

Is This The Real Move?

By Theodore Butler

The sharp, one-day jump in silver certainly focussed everyone’s attention. The obvious question – is it the start of the big move, or just another head fake caused by tech fund/Silver Manager manipulative COMEX trading?

Before I answer, I want to remind you that I have a distinct advantage over most people in attempting to answer that question. I know that many of you won’t get to see my answer in print for as long as 2 weeks from today, July 24. The advantage I have is knowing just how stupid I could look then. It’s something I’d prefer to avoid. Besides, my answer is I don’t know. But I have another answer, namely, that is not the best question. The best question is what to do about it?

Fortunately, that’s an easy question to answer. I admit, it could be a fake out, and silver investors could be disappointed, once again. If that happens, it happens. You’ve been through it before and it didn’t kill you. It won’t kill you if it happens again. But it will be devastating if it is the real move, and you intentionally have less than a full physical silver position on. Is the risk of being less than fully invested worth the cost of missing the big move loaded to the gills? It’s one thing for someone not to buy or hold silver, if they haven’t taken the time to study it. It’s quite another thing to know the story and not to be in with both feet. Don’t get cute and try to time the market with real silver. Remember – Dimes to the downside, dollars to the upside.

I don’t know if this is the real move, but it feels different than any recent move. For one thing, we came out of the gate fast, up 6% in a day. It could just have easily been 16%, or 60%. My point is that this was not a “normal” move, but perhaps a taste of what’s to come. The only news I read was bearish, namely Kodak’s slow film sales. Certainly, that didn’t cause prices to jump. This confirms that silver moves on COMEX paper trading only. Shame on the CFTC for not seeing this.

Nightmare on Silver Options Street?

As I wrote last March, in “A Very Interesting Trade”, there were large options transactions back then in COMEX silver call options. And there’s been a lot more of these large call options recently. I’d like to point out that the traders who sell call options might find themselves in trouble as a result of recent price advances in silver. Selling call options is a major component of the entire short position. Traders sell options to earn the premium that the buyer pays for the option. The selling is done on a leveraged or margin basis, The vast majority of calls are naked. Very little real silver backs them up. Since over 95% of all call options expire worthless, the option sellers have had a field day, making money for many years on the COMEX, because the sellers get to keep the option premiums. In fact, it is a big reason why someone might manipulate the price of silver, just to capture the premiums that could be gained by keeping the price of silver stagnant. I’m talking many hundreds of millions of dollars over the years, hardly a minor incentive.

As of the close of business, July 24, there were over 62,000 COMEX silver call option contracts open – meaning 62,000 call longs (or buyers) and 62,000 call shorts. That’s the equivalent of 310 million ounces of silver. This is in addition to the 95,000 short (and long) futures contracts outstanding, or 475 million ounces. Yes, that means 785 million total ounces are held short as of today, more than 5 times total world visible inventories. Outrageous. But let’s just focus on the 310 million ounces short in call options.

The sudden jump in silver prices may have sent the silver call shorts into financial peril. Certainly, if silver prices climb from here, there could be catastrophic consequences for many call sellers. Here’s why – to sell a call short, generally requires very little margin, especially for options that have a strike price above the market. These are termed, “out of the money” options, meaning that there is no intrinsic value. (For instance, a call option on silver with a $5.50 strike price won’t be worth much with silver under $5.00 per ounce and would be considered, out of the money). As such, there is very little margin required for a call seller of these out of the money options, and generally very little risk, given how flat the price of silver has been for so long.

The typical margin required to be deposited by a seller of one such out of the money silver call is $100. (I think exchange rules allow the margin to be as little as $10 per contract). If someone were to short 100 such option contracts, out of 62,000 open, the margin required to be deposited would only be $10,000, or even a lot, lot less. Each contract covers 5000 troy ounce of silver. In this example, 100 contracts involve 500,000 ounces of silver. The seller is obligated to the buyer for any amount over the strike price. In this example, if the price of silver jumped a dollar over the strike price, the seller would be obligated to deposit $500,000 with his clearing broker, if the seller didn’t buy back his contract.

We haven’t moved a dollar in silver (yet), but we have moved a quick 30 cents or so. Just the move we have seen so far, has caused many margin calls to be issued to short option sellers. In the example of 100 contracts being short for $10,000 total margin deposit requirement, the margin requirement could easily now be $100,000 or much more, for many such 100 contract positions. It’s hard for most traders to come up with such funds overnight, especially when unexpected. Certainly, higher silver prices from here would result in additional shocking margin calls.

At some point, higher silver prices will break the back of many option sellers. Unable to come up with massive amounts of money for margin, there is only one other choice for the option sellers – buy silver in some form (futures or options) to stop the hemorrhaging. This is what happened in September 1999 in the COMEX gold market, when the Washington Agreement, limiting gold selling and leasing was announced. It was short covering from the gold call option seller that caused the price of gold to jump $80 very quickly. That same thing can and may occur in silver. If it does, it will happen quickly and exert a powerful upside boost to the price. If we go higher in silver from here, it could be a real nightmare for the silver call option sellers and boost the price of silver in a monumental manner.

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By James Cook

Once a week I like to call the South-of-France and talk with the economist, Kurt Richebacher. We have been friends for years. In 1997, he came to visit us and stayed at my home. He gave a talk to our broker staff and the two of us had many interesting discussions. What stands out is the accuracy of what he had to say about future economic events. He predicted the 1998 Asian crisis, the faltering U.S. economy, the stock crash and today’s lack of a meaningful recovery. Compare that to the community of U.S. economists who have been repeatedly wrong. (Not that they’ve learned from it.) Mr. Richebacher is the only economist on earth to be so right so early.

I think it’s a symptom of the times that the guy who has been right gets ignored, but those who have been wrong get wide currency. The equity culture has mesmerized America. There’s no listening to reason among investors. You might as well tell the sorry characters who blow their entire paycheck at the quarter slot machines to stop gambling. The growth in speculation, and the derivatives that facilitate it, is a measure of our dysfunction. Prompted by the greatest credit excesses in history, the nation has become a great casino, crowded with speculators, runaway consumers and subsidized pleasure seekers.

Lately the histrionics about an imminent recovery have become delusional. The worse it looks, the higher the decibels emanating from Wall Street. Mr. Richebacher explains, “Reading mostly bullish reports about the U.S. economy, it strikes us that they are all rich in optimistic assumptions and predictions, but very short on critical analysis of facts and causes. It is simply their foregone conclusion that the U.S. economy and its financial system are fundamentally sound…..

“Looking at the levels from where stock prices have come since the spring of 2000, the excitement about the rebound of the stock markets since March appears to us as too much ado about nothing. The truly decisive question is and remains, of course, the economy’s further performance.

“The actual economic data do not give the slightest reasons for expecting or predicting an imminent, strong recovery of the U.S. economy. At the bottom of these optimistic forecasts is little more than the hope that the unusually aggressive measures undertaken by the government and the Federal Reserve will be effective in stimulating the economy.

“For sure, America’s economy is at its most critical juncture. Hopes are riding high that the aggressive stimulative measures, implemented by the government and Federal Reserve, will not fail to revitalize it. Monetary and fiscal policies are operating with wide open spigots. Much smaller doses of both have always helped in the past. Why should these much bigger doses fail this time?

“There is a simple answer: Past recessions were all chiefly caused by monetary tightening imposing a credit crunch on consumers and businesses. By easing credit, the central banks removed the recession’s cause, and basically healthy economies took off again.

“For the first time ever in the postwar period, many countries around the world, not only America, are experiencing a prolonged economic downturn in the absence of any monetary tightening. In essence, there must be causes other than a credit crunch.

“Nobody questions the need for action. But it should be clear that easy money can only be the cure for tight money, not for any other causes depressing the economy. For us, the real and disturbing story about the U.S. economy is that, with all its imbalances, it has reached the stage where it requires permanent, massive monetary and fiscal stimulus to garner just a tepid economic response – and to prevent the various bubbles from deflating. All this is definitely not prone to create a healthy economy capable of self-sustaining growth.

“The fundamental dilemma today is that the Greenspan Fed and Wall Street are making desperate efforts to sustain unsustainable bubbles. In the end, all bubbles are unsustainable because in order to stay afloat they have to inflate endlessly. Our greatest fear is now the bond bubble. Its influences are pervading the whole economy and the whole financial system, and its bursting may have apocalyptic consequences…..

“Once more, America’s numerous consensus economists have convinced themselves that the U.S. economy is on the verge of the desired revival they are persistently forecasting. They enumerate two main reasons: first, better economic data, and second, stimulation of unprecedented magnitude – record-low interest rates, huge tax cuts and the falling dollar.

“Just in early June, Mr. Greenspan told a banking conference in Berlin via satellite that there was still no evidence of a postwar acceleration in the U.S. economy. Most American economic data, labor market data in particular, leave no doubt as to the direction of the economy’s next major move – down, not up.”

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