For us, one of the keys to taking a new position in any commodity or equity that is closely associated with a commodity is an analysis of the COT data. COT stands for "Commitments of Traders," essentially a report providing a weekly snapshot of the trading activity of futures traders broken down into categories including commercial traders, large and small speculators. The data is released weekly by the Commodity Futures Trading Commission (CFTC), a government agency. Generally, commercial traders actually produce or intend to make or take delivery of a particular commodity. Speculators do not usually make or take delivery, although they can.
An adage among commodity traders is "follow the elephants," the commercial traders. The theory (probably wise) is that the trading activity of commercial traders who know the economics of their business better than anyone, is a leading indicator of the next likely price move in the market for the commodity they trade. By doing what the commercial traders do, an investor/trader can obtain an edge over the large and small speculators who are typically wrong about the market's next price move or trend. That's the theory, anyway.
One problem with following silver elephants is that they are always short. But sometimes they are much less short than at others; and this is one key to effective analysis of the data. Another problem with following silver elephants is that the commercial traders do not disclose their trading objectives or time horizons for the positions that they hold, or even whether their short and long positions are hedged in other ways, since these traders often actually handle the physical commodity.
Unless you have access to the thinking patterns and physical commodity transactions of the "elephants," you can wait a long time for the market to do what the commercials appear to be indicating by their futures trading activity. Holding open positions and waiting on a market like silver can be treacherous due to the volatility of the price action in silver and the size of a given investor's capital account.
Nevertheless, analyzing COT data is a must for anyone trading commodities or equities whose businesses are closely tied to or influenced by fluctuations in commodity prices. COT data is released by the CFTC weekly now; and you can view it in chart form free of charge.
We think that the trend in the data released for commercial silver traders culminating in the report issued last week has actionable trading significance. Presently, the silver elephants have the fewest number of net short positions in memory, even fewer net short positions than in the last quarter of 2008. We say "net" because the raw number of short contracts presently held by commercials (60,602) is actually higher than the number of short contracts held (56,314) by commercials in late 2008. We think that data comparison with late 2008 is relevant because it describes the bottom for the last sustained major market sell-off in silver before the one we are now witnessing.
But if the number of commercial silver short contracts is higher than the number of short contracts held by the elephants in late 2008, how is that helpful to us in an examination of this data? We believe that the key is the trend in the number of long contracts held by the silver elephants. The percentage of commercials that are bullish on silver is at an historic high. Incredibly, 45% of commercial traders are bullish on silver, holding more than 48,000 long contracts.
The trend in the gap between commercial long and short contracts has been narrowing for nearly six months. It is at an historic pinch point. We do not believe that the gap will narrow much further, if at all. While anything is possible, we view the probability as very low that the commercial group of traders who historically have been net short silver will totally abandon their traditional trading patterns. Stated more bluntly, it will not be different this time.
Of course, there are numerous additional factors that one should consider in assessing the next major price move in silver. The overall economy and the price pattern and trend of gold come to mind, as well as a number of other technical and fundamental factors. However, we view this as an opportunity to run with a herd of elephants, if not bulls.
Over the past six months, we have been repeatedly selling cash secured puts into the weakness of the precious metals mining sector. In this way we are long Silver Wheaton Corp. (SLW), Hecla Mining Co. (HL) and other precious metal miners. It gives us an additional cushion in the event there is a continuing decline in prices; and it lowers our effective average entry point for whatever time it takes for the elephants to change direction.