A rise in performance bond levels will usually cause a transient reduction in the price of any commodity, and silver is no exception. Most long buyers are undercapitalized and buy more than they can afford, no matter how huge their assets might be. Usually, they keep the minimum amount of the performance bond in their accounts.
Once a margin hike occurs, some are thrown out of their positions by margin calls. Many flee because experience tells them that the price is about to go down. And still others are flushed out because as a result of the first two situations noted above, their stop-loss orders are triggered. This usually ends with a steep price drop, depending on how high the performance bond levels are moved up.
We noted in previous articles that COMEX has been serially increasing margin requirements for holding silver futures contracts. This has happened three times in the last nine days now. Although some commenters claim that the hikes are happening because of the need to maintain leverage to a fast rising silver price, it was done, yet again, on May 2, 2011, when prices fell.
According to an article published in Zero Hedge, we've learned that MF Global hiked silver margins way beyond the official level, to roughly $25k per contract. Similarly, ThinkorSwim has raised margin requirements on SI $30,037.50 and $6,007.50 for the smaller 1,000 ounce contract? That is about two and a half times what the margin requirement was prior to last Friday's official COMEX performance bond increase. We have not been able to independently confirm this increase, but Zero Hedge has been accurate in the past.
If this is being done at those two broker-dealers, it is probable that the same thing is going to be done by many other futures dealers. MF Global is a very big futures broker and a big clearing member of the CME Group. ThinkorSwim is a broker which uses the services of a major futures clearing broker-agent who services retail brokerage houses. The ThinkorSwim margin requirement levels will be duplicated at dozens of other brokerages which use the same clearing house. We cannot help but wonder whether the proprietary trading divisions of MF Global and the clearing broker being used by ThinkorSwim are short silver? We don't know at at the moment, but it would be very interesting to find out.
Investors who do not want to be flushed out of their positions by an unexpected margin call need to regularly inquire with their brokers because, as the price continues rising, the margins are being constantly changed. The remaining open interest in silver would be inconsequential in normal times. However, right now, the demand for physical silver is so high and the inventory is so low that intense pressure is being put upon the silvers futures market. We tend to think that the real battle is in the form of OTC delivery demands being made upon London based dealers. To meet those demands, we are seeing, and we will continue to see financial institutions that participate in the ETF SLV continue to cash in their shares in exchange for baskets of physical silver. In our view, the reduction in the size of SLV's holdings is a result of this process and not any form of exit by average investors.
We don't know what is motivating the clearing brokers to dramatically raise performance bonds. The raises can only be justified if they were being applied to short sellers and new buyers who are buying their positions at the current prices. But they are being applied to all long buyers, including those who may have bought when the price was half of what it is now. We do know that these actions have but one effect. They force a transient long liquidation of silver futures positions, and that is exactly what happened on May 2, 2011. They drive down the so-called "spot" price for silver in a transient manner. This has also happened.
The "spot" price was once thought of as being the result of so-called "price discovery" at the futures exchanges and in the bullion market in London. The spot price is now viewed, by many, as a false price that is gamed. This is because on February 3, 2010, Andrew Maguire, a former Goldman Sachs commodities trader who is now independent, emailed the CFTC some valuable information about a “manipulation event”.
He described it with extraordinary detail, and predicted accurately what would happen just two days later. The emails have been released publicly and are now posted here. The extraordinary accuracy helps us understand what is happening in the silver market. Why prices are soaring, why prices are defying traditional technical analysis and why so many investors no longer give any credence to the so-called "spot" and "London fix" prices. The price of silver which, based on the emails has been artificially suppressed, is not really doing anything extraordinary. It is simply an asset that has been mispriced by the market for a very long time and is unwinding to fair market value.
The ongoing price drop represents an opportunity for people to buy silver at a price that is cheaper than it probably should be right now. We believe that this is exactly what a lot of smart people are going to do. A severe drop in spot prices created by the margin changes could last anywhere from a few hours to a few days- or even a few weeks- if they keep raising the bond levels. But the spot price is becoming increasingly irrelevant. If arbitragers believe that COMEX or the LBMA will deliver the silver promised in derivatives, they will buy there and sell in the physical market, forcing prices up again. Alternatively, if a COMEX or LBMA member bank default on silver lies ahead, the spot price will be discredited forever.
Trying to find the lowest price during a price dip is very difficult. Just be happy with buying at a "good" price, considerably lower than you would have had to pay just a short time ago. Sales in the physical market were bigger than ever, even when the spot price was driven close to $50 per ounce. So the exact price you pay now may not matter. You need to play it by ear as these events unfold. Our previous articles (I, II, III, IV) can help provide additional information.
There are huge opportunities for traders willing to take big risks in the silver market right now. This may represent a last great opportunity to buy silver at a cheaper price. The depth of this dip will largely depend on how fast over-leveraged long buyers can be flushed out of the futures markets; on how fast some of them can put in new orders after their stop-losses are triggered; on how many times the performance bond levels are raised; and on how fast people can wire in more money to their brokers to get back into the game.
Seemingly "managed" price drops usually last less than a week, and often no more than a day or two before running out of steam. After that, a shell-shocked, disspirited market is utilized, for the most part, to maintain a lower price for a longer period of time. In the aftermath of the McGuire emails, however, it is not likely that people will remain disspirited for a long time. People now know why silver is declining.
An ominous problem continues to be faced by silver shorts. For the first time, a lot of serious investors who are not undercapitalized are a part of the silver market. They opportunistically buy cash positions as leveraged longs are flushed out. Therefore, we are not likely to see a traditional "shell-shocked" market arising out of this. Even if peformance bonds are raised to 100%, the difficulty in finding silver to make deliveries into the OTC market will continue. That will force prices up again.
Conservative long term investors might also want to consider platinum. By our estimates, it will be in serious shortage in a year or two. JP Morgan Chase is buying physical bars of platinum like hotcakes. Platinum has a similar concentrated short position at the futures markets, having been subjected to the same type of behavior by big futures market players in the past. It also has huge "unallocated" storage ratios, and the mining supply each year is miniscule. The mining supply continues to be relatively stagnant, in spite of higher prices over the last few years. It is costing more and more for miners to extract what platinum is left in the S. African mines, and mining in Zimbabwe is being stymied by political issues.
A 5% shift in jewelry demand away from gold to platinum, as the price of gold and platinum head closer to parity, will lead to a need for 69 tons of additional platinum mining supply each year. The total mining supply, however, is only about 6.9 million troy ounces, or 214 metric tons. The metal is 14.7 times rarer in the earth's crust than gold. All mine production is already spoken for in 2011. Yet, new and important clean air regulations throughout the developed world will require catalytic converters on all new off-road diesel vehicles. That is expected to create about 15.5 tons of new demand. Add 15.5 tons of demand to an already tight market, and you will have a price rise. Add another 69 tons of demand (and perhaps much more) as gold continues to rise in price and be monetized by central bank buying, and you have the makings of a price explosion potentially much larger than what we have seen in the silver market.
When and if you speculate in silver, or in anything else, remember that nothing is a sure thing. We have bought the SIVR ETF on the dip. It is a good trading instrument, but not necessarily the best way to own silver long term. A calculated gamble with a small percent of your assets can be fun and profitable. Just don't put the house, the retirement assets or the "lunch" money at risk. Even if you make a big percentage profit, don't get carried away by it. Speculation by average people should be limited to what they can afford to lose in Las Vegas. Leave the heavy lifting to silver vigilantes.
That being said, you may want to take advantage of the current situation to buy as many beautiful silver coins and small bars as please your eye. They are beautiful and pleasant to look at, feel and hold. They will last as long as you live, and can be passed down to your children and your children's children, long after you are dead. They also happen to be a good long term investment.
Disclosure: I am long SIVR.
Additional disclosure: Long precious metals