With the market showing undeniable strength in the face of an inevitable Greek default, a short-term trading combination has become an intriguing idea: go long silver, and short financials. The play appears to be well-hedged, and both sides offer significant upside.
Silver and gold have been almost completely correlated to the dollar's day-to-day fluctuations recently. Though the dollar's value has obviously always been a major factor in the price of gold and silver, the correlation has been particularly tight as of late. This appears due to increased scrutiny of the EUR/USD exchange rate as a result of the European crisis.
After nearly scraping $50 an ounce in 2011, silver prices collapsed in an astonishing overnight selling-spree in April, leading to a downward trend all the way back down to $26 in December. Buying interest has renewed recently as financial liquidity and risk-taking has returned to the markets. Silver has largely benefited from the rebound in equities, and the small euro bounce to $1.30.
If markets continue to move higher, in conjunction with a short-term, short-covering led rally in the euro, silver offers huge returns. Silver supply was incredibly tight a few weeks ago, as retail investors were unable to purchase silver coins and bars from most sellers, leading to funds like PSLV trading well above their net-asset-value. This supply kink seems to be playing out as we speak: Eric Sprott, manager of the PSLV and PHYS funds, announced a $300 million plan to add to silver holdings. As a result, PHYS' premium fell significantly, but the price of silver soared amidst speculation that a $300 million buying spree is about to take place over the next several months. The concept here is that as premiums are liquidated, the actual price of silver should rise.
Silver's downside risk derives from the potential for significant strengthening in the U.S. dollar. As we draw closer to Greece's default, the euro should resume its downward slide, and the dollar may serve as a safe-haven (though it is anything but). While this doesn't mean silver has to weaken, the recently tight, almost 1 to 1 correlation foretells of lower silver prices in the event of a significantly stronger USD. For this reason, this trade's greatest upside is likely contained to the next 5-6 trading days.
I have written extensively on why financials, particularly investment banks, are at massive risk in the event of a Greek default. While actual asset risk directly related to Greece debts is largely contained, it is the unknown that is the real catalyst and worry. Given the notional derivative risk that US financials have with European banks, there is legitimate catastrophic risk. Firms like Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) have trillions in outstanding derivatives contracts based on their risky exposure to European financial institutions. So while their "net" risk to Europe may appear manageable, their ability to collect on hedges is completely dependent on several counter-parties, who themselves have risky exposure to poorly capitalized institutions. In other words, the risks are innumerable, and the so-called hedging-net could very break in the event of a Greek default. Amazingly, AIG (NYSE:AIG) has actually been a major player in the derivatives market, namely acting as an insurer via CDS, over the past couple of years (pretty terrifying).
For this reason, investor sentiment in U.S. banks should begin to damper over the next several sessions, especially considering the run they've had so far in 2012. The strength seen in financials simply offers a better price at which to short them - not to invest in them.
Over the next several sessions, I expect financials, and the broader market, to sell off heavily. Consequently, the dollar will likely strengthen as it functions as a safe-haven, while the demand for risky assets weakens. Although silver could see some selling pressure, I fully expect buyers to swoop in rather quickly, given the tight short-term supply as of late. In this scenario, I expect shorting financials via (NYSEARCA:SEF), (NYSEARCA:SKF), and (NYSEARCA:FAZ) to vastly outperform a decline in the price of silver ETFs such as (NYSEARCA:PHYS), (NYSEARCA:SLV), and (NYSEARCA:AGQ). Obviously, you need to pair your ETF exposure accordingly, based on your desire (or not) to leverage. I believe this trade offers an interesting, well-hedged, and cheap concept to short-term, speculative traders.
Though I engage in trading from time to time, I fully consider it to be highly speculative, and I keep trading transactions separate from my long-term portfolio.