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Silver and the Unfriendly Bear

By: Daan Joubert, Gold Signals, &

-- Posted 10 March, 2004 | | Source:

The probability that a genuine 24 carat bear squeeze could develop in the Comex division of the Nymex futures market in New York appears to be increasing.

Since South African investors have not been able to go short of equities with ease since the local stock market bubble imploded in 1969 and as we do not have a commodities futures market, we have no significant history of a bear squeeze to illustrate just how painful it can be for those caught in the bear’s embrace. And how profitable it is for those who own the commodity that has been shorted out of sight until the market finally turned.

The last major squeeze on the JSE was when Union Wine was heavily shorted back in the 1980’s (I think), pushing the price of the troubled company’s shares down from quite a few rand to below 20c. Then it turned out that more shares had been shorted than what was available, to trigger a proper bear squeeze. The last short positions were covered at something near R15, about 100 times more than the low price where the squeeze began.

For the uninitiated, a bear squeeze requires the following to develop:

Short selling of some equity or commodity that requires delivery of what has been sold short. On our SAFEX futures exchange most contracts are linked to the nominal value of equity indices. At settlement time, there is no delivery of anything material - all transactions are settled in cash. On the other hand, if one had borrowed some share certificates from a stockbroker to be sold short, the borrowed share certificates have to be returned at some point in time; which means that the short seller later has to purchase the stock in the market again in order to deliver the certificates back to the stock broker. In that case a bear squeeze becomes possible, as in Union Wine

That delivery is required is not enough - an additional requirement is that at the time when short position has to be closed there is not sufficient supply of whatever has been sold short. In other words, the player who is short has a problem when trying to obtain enough stock to cover the short position. Obviously, the tighter the time constraint for delivery and the greater the difference between supply and the size of the short position, the deeper in trouble the short player(s) will be

A third requirement is that the market has to become aware that a short squeeze is possible. If the market does not know this, the player who is short can carefully bid up the price, remaining the best bidder most of the time in a delicate play to drain the market of however much is needed to cover the short position. If the market is aware of the situation, owners of the commodity will hang tight for prices to be bit up by a substantial amount before thinking of selling

An exacerbating factor in a short squeeze is present when the number of market players who have gone short is large. Each of them might have estimated what the available supply is likely to be and adjusted their position accordingly - keeping it within what to them seemed like safe limits, for their own position in isolation. Yet, all the short positions together then by far exceed the normal or expected available supply. With many participants, the first problem is that the total short position grows too large.

Secondly, if only one or perhaps very few players are short of the market, they can agree among each other not to upset the apple cart by being too aggressive in their buying. If they have some time on their side, they could ‘play’ the market, trying to dislodge holders of the stock so that there is an ongoing and quite ample supply coming into the market. If there are too many short sellers, one or more might lose control and begin to buy aggressively, which then triggers a mad scramble among all the players to obtain enough stock to close their short positions.

And it is in this final case when the Big Bad Bear turns traitor on those on whom she had smiled before, and wraps her claws around players who earlier had though she was on their side; players who had thought that weakness in the market, often helped on by the additional supply they were adding to the market with their short selling, in due course would make them a good profit. Which it did, until they overplayed their hands.

At first the bear smiled on their efforts and the short sellers made good profit - but only on paper, except for the very few who cashed in before the bear trend was over and the squeeze started. The rest, more greedy, thought the bear trend would last and last - but this hope fails when the market begins to realise how large the short position is and how much profit can be made by buying up whatever supply is available while the short sellers are still dreaming of how much profit they are going to make. A situation that is a speculator’s dream.

Then, as the squeeze takes effect, the short sellers realise their problem and rush in to buy the scraps that are left over - too late, most often. Obviously, the higher the price moves, the more desperate short seller buying gets - and it soon reaches a full panic as the price rockets higher and they face the prospect of being financially wiped out.

The silver market

On Comex the idea is that owners of whatever commodity is listed on the exchange - say silver - are using the market to hedge against a loss in value of their physical stocks of that commodity. On the other side of the transaction are the speculators who believe the price is going to go higher.

Under normal circumstances these two classes roughly balance each other as they are guided in their decision making by what the physical market is doing. That is where the real price is being set. Comex also places limits on the magnitude of the positions in the futures market relative to the size of the physical market to prevent problems that can arise either through excessive greed or through attempts to manipulate the physical market via the futures market. Silver and gold, strangely enough, have no such limits.

Since Comex is inherently a commodities exchange, at settlement time the owners of the long side of the contracts have to decide whether they want physical delivery of the silver represented by their contracts or whether they want to settle in cash. The latter is in effect done by either selling their long contracts to close their positions or, alternatively, to buy more time by rolling their position over into the next futures contract.

Yet one cannot sit on a position to the last day when the futures contract expires and then claim delivery - that is not fair to the seller of the contract who needs some warning that he will be called for delivery. The "First notice day" is the last Friday of the month before the contract expires. In the case of the March Comex contracts - which like all other US futures expires on the third Friday of the month, i.e. the next expiry is on the 19th March. By keeping the contract open beyond the ‘First notice day‘ - 27th February in this case - the holder of the long future is indicating that he intends to ask for delivery.

This gives the seller of the contract 3 weeks to ensure that delivery will be possible.

At the moment, with a few days left to go to the expiry of the March contract , delivery is taking place - it is not known to the author whether the amount of silver being asked for delivery is more than usual, although it seems to be. It nevertheless does seem as if there will be ample silver in the Comex warehouse for the number of contracts that moved into the delivery period for the March contract.

This might well be because the potential for a bear squeeze is not yet widely known. The amount of silver for delivery is quite large relative to available silver stock, but can be met from the warehouse. One European bank taking a large bite, equal to about a third of the total number of contracts, which indicates interest from a large player. With some draw down of the Comex silver supply sure to attract wider attention, and perhaps more large buyers of silver, the May silver contract must be seen as the new favourite for the appearance of the Bear’s embrace.

The situation is also becoming ripe for a coup that can only be executed by a really large player - something that apparently was done a number of years ago.

The system is simple:

Purchase a good number of silver options across a spread of strike prices, even some way out of the money (i.e. a little above the ruling spot price) options (buy into many strike prices so that there is not much to attract attention and raise suspicions)

Go to the owners of available silver in the Comex warehouses and take an option on their silver, to expire after the end of the futures contract

When the time comes, exercise Comex the options, even those some distance out of the money and ask for delivery on the futures that are obtained

When the short sellers try to buy the warehouse silver on which you have an option, wait for them to bid up the price before you sell ‘your’ silver to them so that they can then deliver the silver back to you

The silver that is delivered can either be recycled through the warehouse to other short sellers who still have not been able to deliver, or it can be sold in the open market at a price that will be so far above the recent ruling spot price, where the options were taken on, that even well out of the money options show a good profit

Market talk at the end of 1997 - when the price of silver spiked from $5,80 to $7,90 - was that someone had pulled off a coup of this nature and made a small fortune. Whether this can still be done is a good question, as there now might be regulations to prevent a repeat.

Even so, the fact is that the silver short position is massive, compared to the available silver - not only the silver in the Comes warehouses, but compared to all silver above ground. This makes a full bear squeeze more than just a pipe dream; it can happen.

All it needs is for enough people - speculators and investors - to become aware of the situation and to purchase calls on silver that they intend to exercise in May for delivery.

If enough people do so, the squeeze will be on and the silver price will run.

Things can still hot up in March, but it is beginning to look more as if we have to wait for May for the bear embrace to really take hold.

Be prepared.

Daan Joubert

March 2004

-- Posted 10 March, 2004 | |

Last Three Articles by Daan Joubert, Gold Signals

Silver Leading the Way
15 March, 2004

Silver and the Unfriendly Bear
10 March, 2004

The Silver Bullet
21 January, 2004

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