Use SLV To Trade The Growing Silver Surplus

| About: iShares Silver (SLV)

In July, silver was trading at around $27 per ounce. The week of August 20, it jumped to $31. It has moved around in a range since then, and is now almost at the same level as at the end of that week when the price spiked in August.

The bull case has been the new quantitative easing announced in September and, more recently, rumors of a shortage of silver. The U.S. Mint helped to feed these rumors by its announcement that it has run out of Silver Eagles. There are other rumors circulating on the Internet as well.

If this were indeed true, the obvious play would be to buy silver and an easy way to do that is to buy SLV. SLV is an Exchange Traded Fund that closely tracks the price of silver.

I am a big believer in making trade decisions based on good data, rather than rumors on the Internet. The shortage at the U.S. Mint is an interesting data point, but it may be a weak proxy for the true state of the global silver market. There are many conceivable reasons why they could be out of coins without silver necessarily being in shortage.

There is a way to look at fundamentals in the silver market. The silver basis is the price in the futures market minus the price in the spot market. It is defined as Future(bid) - Spot(ask). The basis is the profit one could make by simultaneously buying physical silver and selling a futures contract against it. Quoted as an annualized percentage, it is helpful in understanding the current market conditions.

If the basis is positive and rising, it means that the good is becoming more abundant (or less scarce) in the market. Think about it, if a good is in shortage then it will not be possible to make a profit in warehousing it. If there is a serious shortage the basis will be negative to pull silver out of warehousing, out of carry trades.

Here is a graph of the silver basis (December 2013 contract) since July.

(Click to enlarge)

In the beginning of July, one could have earned an annualized return of around 0.1% to carry silver for 17 months. As of Friday, one could earn about 0.65% with an 11-month commitment. Silver in the spot market is much less tight today. The marginal use of silver is now the carry trade, but in July it is a good assumption that no one would have been carrying silver for a mere rate of 0.1%.

Silver has become far less scarce than it was.

The challenge in calling for the silver price to fall is that silver is a monetary metal (along with gold). In this era of "unconventional policy responses" by central banks, one should never short "naked" a monetary metal. There is no guarantee that the silver price will fall. It could indeed rise substantially.

So, let's look at the same graph but with the gold basis added.

(Click to enlarge)

Gold is in the exact opposite trend. Gold has been becoming scarcer since July. We can speculate about the reasons and read the rumors on the Internet. But for trading purposes, the theme is clear. Gold is becoming more scarce and silver is becoming less scarce.

It may be difficult to determine the price of silver, but if we eliminate the dollar and central banks as a risk factor, we're left with a simpler task. Silver will become cheaper relative to gold.

I recommend a long / short trade pair. Go long GLD and short SLV. Here is a graph of the gold:silver ratio. This is simply the gold price divided by the silver price.

(Click to enlarge)

From a technical perspective, it appears to be making higher lows and higher highs. It's hard to call an exact target, but at least 60 is probable, and it is quite possibly going much higher than that.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am long gold and short silver, though not using GLD and SLV

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