-- Posted 15 May, 2011 | | Discuss This Article - Comments:

Every few months, silver has a stunning collapse and the whole world seems astonished by the ferocity of the move. I think it’s time that we all take a step back and accept that silver is a wild animal. At any time, it can move 30% and that isn’t out of the normal—in fact, that is the normal.

Every single investment product has its own personality. Silver is volatile. Get used to it. If you’re a long term investor, this should not really matter. I bought mine in the mid-single digits. I haven’t sold any and wouldn’t sell any at these prices. I look at these movements with mild humor and nothing more. However, I know people who have been swept out with the tide in the most recent collapse.

Before you invest in something, you need to understand how it trades and then size it appropriately. I’m always amazed at how people size things larger than the movements that they can stomach. In silver, this is especially true as the tin-foil-hatter types like to scare people into owning it. As silver goes up, skeptical investors suddenly think they have squeezed some massively short banking group and unraveled the secret cabal that has kept silver down for years. They think silver will go parabolic and they pile in. When silver eventually goes parabolic, it will not be because the bankers are blowing up. It will be because the US Dollar is, but that’s a different story for a different time.

Futures allow people to use leverage—often too much leverage. If you’re using leverage, as something goes up, your leverage ratio declines because you are building equity. This allows you to add to your position and keep the same leverage ratio. The problem is that when something goes down, your leverage ratio then expands rapidly as you’re consuming equity. Suddenly a 3:1 leverage position at $45 silver is a 4:1 leverage ratio at $40. A small $5 move has knocked out a third of your equity. Then come the margin calls and exchange margin requirement changes. Is it any wonder why silver is volatile? I’ve watched silver for nearly a decade now. Every time it has a 10% drop, you can almost be sure that it will lead to a 30% drop because even the ‘conservatively margined’ guys eventually get liquidated.

Which brings me to the point at hand, there is no such thing as conservatively margined. Given a big enough move, any small amount of leverage is deadly to your portfolio. It’s tempting on the way up, but dangerous on the way down. I simply refuse to use it. But you can always take advantage of others using margin. Two or three times a year, all the silver traders get liquidated. I always keep some extra capital on hand. I wait until it’s a week into the liquidation so I know I’m not too early, and then I start buying on the way down. If it goes lower, I buy a few more. It’s almost always good for a nice pop when the margin calls end. I play small as I may have to own it for a bit. Use the liquidations to your advantage, but remember to sell the pops and keep your core position. You don’t want to get too big in a product like this. Silver is one wild animal.

Harris Kupperman

http://adventuresincapitalism.com/