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The details of important silver market reform will be decided in the next two months. The new Frank-Dodd Financial Reform law includes updated speculative position limits for silver. New position limits were supposed to be imposed by the middle of January. Instead, the Commodity Futures Trading Commission (CFTC) has settled on simply determining position limits by the middle of January and implementing the new limits gradually. In short, regulators will decide upon the silver market position limit in the next two months.

The issue of whether these limits are right or wrong is beyond us. These limits will be imposed and investment strategies must be adjusted accordingly. The new position limit can affect the price of silver. Silver investors have a lot at stake and should participate in the discussion once they’ve done some investigating. Doing one’s homework in the silver market includes studying the CFTC’s Commitments of Traders (COT) report. (The CFTC publishes the COT report every Friday at 3:30pm.) It is impossible to understand the potential impact of reform without looking at the structure of the silver market. The COT report reveals that the market structure in silver is unique: there is a large concentrated short position in silver.

According to the November 16, COT report, the four largest commercial traders are net short nearly 235 million ounces of silver. Open interest in the silver market, after removing spread positions, is about 430 million ounces. This means the net short position of the four largest silver traders constitutes 54.6% of open interest on the COMEX.

Admittedly, concentration levels have fallen in the last year. For instance, as of November 3, 2009, the four largest commercial traders were net short about 311 million ounces while open interest in the silver market (less spreading) was about 433 million ounces. At that time, the net short position of the four largest silver traders constituted 71.9% of open interest on the COMEX. Concentration levels have fallen from 71.9% to 54.6% since last November. This reduction in the concentrated short position over the last year has been accompanied by rising silver prices. The price of silver is up about 60% since last November, from about $17 to more than $27 per ounce.

The top four commercials have not increased their short position during the current six-week rally. In fact, they have been reducing their short position. This is highly unusual, and the new silver reform explains the commercials’ sudden change of behavior. In this case, a serious threat of position limits has been enough to cause a reduction in concentration.

Position limits exist to prevent excessive concentration. A successful position limit will result in less concentration. Reducing concentration in this case entails short covering. Closing silver short positions means short sellers are buying silver, and, all else equal, driving up silver prices. Rising silver prices puts more pressure on the shorts to cover, and a viscous cycle of rising prices ensues. This is known as a short squeeze. (It is likely the CFTC would place restrictions on future short selling rather than demanding the big shorts immediately satisfy the new position limit. The CFTC could make it illegal for the big shorts to increase their short position. All else equal, this would still mean higher prices because the largest seller would be incapable of selling.)

Whether the new position limit will affect price depends on the legitimacy of the limit. The two most important issues are the hedging exemptions and the actual size of the position limit. Commodity futures markets exist so consumers and producers can mitigate price risk. Speculators provide liquidity and are therefore beneficial, but commodity futures markets do not exist for speculators. Hedging exemptions for speculators contradicts the purpose of speculative position limits. It follows that hedging exemptions should only be granted to legitimate producers and consumers of silver. Hedging exemptions should be limited to the amount of price risk assumed by producers or consumers.

The size of the position limit should be based on world production. Esteemed silver analyst Ted Butler has argued for a position limit of 1,500 contracts (7.5 million ounces or 1% of annual production). Mr. Butler’s one percent solution is highly reasonable and persuasive. He makes an excellent case for applying a 1% speculative position limit to all commodities.

There are arguments for even lower position limits in silver. The position limit in gold is .7642% of ten year average world production. Multiplying gold’s position limit of .7642% by ten year average silver production yields a comparable silver position limit of 5,262,589 ounces. In short, 1,051.3 contracts is the silver position limit consistent with gold’s limit. Even using record 2009 production data indicates the position limit in silver should be no more than 1,200 contracts. In summary, a silver position limit of 1,000 to 1,200 contracts is consistent with the current position limit in gold. A position limit between 1,000 and 1,500 contracts will curb concentration without adversely affecting liquidity.

The commercials have deep pockets and they will resist changes in the direction toward more freedom in the silver market. Individual silver investors can take comfort in numbers. Silver investors should unite, and inundate the CFTC with comments regarding the silver position limit over the next two months. All investors benefit from each comment to the CFTC about silver. Comments to the CFTC about silver concentration, position limits, and hedge exemptions will remind regulators that investors are vigilant and demand free markets.

Disclosure: Author long physical silver

Source: Calling All Silver Investors