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Silver Futures CoT

Adam Hamilton
Sep 9, 2005

While September marks the dawn of the seasonally strong time of year for silver, the white metal hasn't fared well lately. It has spent the last six months or so largely grinding sideways, yielding no traction for bulls or bears.

This episode has been particularly trying for investors deployed in silver to ride the ongoing commodities bull. Silver is unique among commodities and has extraordinary potential. It is a relatively small market largely supplied by byproduct silver from base-metal mining. Regardless of how high silver prices run, base-metal miners are not able to ramp up their silver production rapidly.

This inelastic supply is coupled with even more inelastic industrial demand. Silver's unique physical properties make it essential for many manufactured products. But since these products use such tiny quantities of silver per unit, its price can rise without significantly retarding industrial demand. And pure speculative demand stacks on top of this, no other major commodity rockets as fast as silver when speculators start lusting after it.

Thus, silver should be thriving in our commodities bull. In recent weeks I have been pondering silver's disappointing performance of late and even wrote about it in depth in the new September issue of our Zeal Intelligence monthly newsletter. As I researched silver, one troubling theme kept recurring.

A growing number of investors are becoming convinced that games are being played in the silver futures market to either retard its advance or cap it outright. Since I have clients asking me about these theses with increasing regularity, this week I would like to take a look at the raw silver futures data directly from the US Commodity Futures Trading Commission and see if anything odd emerges.

The raw data analyzed below was obtained from the CFTC's famous Commitments of Traders reports that it publishes weekly. These CoTs are data-rich and offer all kinds of valuable information on long and short positions that traders are taking in commodities futures. Charted over time, the CoT numbers help illuminate long-term futures trading trends that can affect commodities prices.

Before delving into the underlying futures data though, it is very important to understand some baseline facts on futures. Investors who attempt to analyze futures data without bearing these truths in mind run the risk of seriously misinterpreting the data and running into trouble.

Futures can either be bought first then sold later or sold first and then bought back later. Traders buying futures now with the intent to sell later are longs, they benefit when the underlying commodity price rises. Taking the other side of the longs' trades are the shorts. They sell futures now and then buy them back later to cover their positions. They benefit when the underlying commodity price falls.

Every single futures contract has both a long and a short side, two traders taking the opposite sides of one trade. Thus, the total number of longs and shorts in any futures market, including silver, is always in perfect parity. Longs can never exceed shorts or vice versa. This is really important because any silver futures manipulation theses must acknowledge the fact that every silver short in existence is perfectly offset by a long, always.

The total number of silver futures contracts outstanding at any time is known as open interest. In order for open interest to grow as more traders participate in the silver futures market, new longs and shorts added must be equal. Since futures are a zero-sum game, meaning one trader's win is another trader's direct loss, it is impossible for new shorts to be added without offsetting new longs.

So if anyone attempted to manipulate silver prices via tactical silver futures trading, they cannot do it by growing shorts alone. Every short contract must have a long out there who wants to buy it. At least two offsetting traders directly competing against each other are necessary to grow open interest. Shorts cannot play this game alone in isolation. It takes two to tango in futures!

The actual open interest in silver futures has grown nicely in this silver bull to date, it has doubled. Each contract outstanding at any given time represents two independent traders, one on the long side of the contract and another offsetting on the short side. This chart showing rising silver OI is absolutely typical of futures behavior in any commodities bull market.

One of the core axioms of the markets is that nothing begets buying interest like higher prices. Whether it was NASDAQ in 1999, real estate today, or commodities tomorrow, the higher the prices of a particular asset class rise the more investors and speculators become interested in riding the bull trend. Thus it is totally natural and expected for futures open interest to rise continually as long as its underlying bull market persists.

Earlier this year I did some similar research in gold futures and the exact same bull-market OI signature showed up. The garden-variety normalcy of continuously growing OI during secular bull markets is crucial for investors to understand. The reason is some analysts advance theories stating that an old OI high being reached means it is time to sell. This is not often true in an ongoing bull market.

In this chart above, for example, note the OI spike to 110k silver futures contracts outstanding in mid-2003. Some folks believed that this new bull-to-date OI high established a new horizontal resistance zone that silver would not be able to overcome, so next time OI ran near 110k they advocated selling. Yet, in late 2003 silver once again hit 110k OI and then promptly rocketed higher in its largest bull-to-date upleg! And a fresh new OI high above 120k was soon established.

It is natural for open interest in any market to grow as long as rising prices are attracting in new traders, as long as bull markets persist. Investors should expect existing bull-to-date OI highs to give way to new higher OI highs as the bull marches on. Establishing horizontal resistance zones based on previous bull-to-date OI highs is not prudent and usually leads to poor trading decisions.

In reality, OI runs in an upward-sloping trend pipe in a bull market. The rising support and resistance lines currently binding silver's OI are drawn in red above. Interestingly, the position of silver's OI in its uptrend can even be used as a trading signal.

When silver OI is near its lower support line, it tends to be a great time to buy for another run higher. This is readily apparent in this chart if you carefully examine each OI support intercept relative to the behavior of the silver price in the months following. Low OI is a useful buy signal because it only happens when silver speculators are bored because prices have been low for awhile. When prices are languishing capital migrates elsewhere reducing silver OI but it is at these very sentiment lows where the seeds of new rallies are sown.

Conversely silver OI trading near its upper resistance line generally marks great times to sell silver or at least be neutral. While not always the case, high OI often occurs as traders are growing too enthusiastic about silver over the short term and an interim top is being carved. The contrarian play to make at these times is to fade the short-term euphoria and wait for OI to once again drop as prices decay in one of their periodic bull-market corrections.

Since silver's OI uptrend looks completely normal within the context of this bull, any silver manipulation theses must look elsewhere for evidence. While total longs and shorts outstanding are always perfectly equal, there are actually three different classes of futures traders delineated by the Commitments of Traders report from the CFTC. They are commercial hedgers, non-commercial large speculators, and non-reportable small speculators.

Hedgers are directly involved in the silver markets in some way. They use the futures markets to offload their price risk to speculators. Silver miners use futures contracts to lock in their silver selling price now for silver delivered later to ensure their business cashflows are predictable and adequate. Silver industrial users, also hedgers, use futures to lock in their buying price today for silver they will need later for their products.

Truly the only reason futures markets exist is so hedgers buying and selling commodities can offload the risk of price fluctuations to willing speculators. These speculators crave this price risk as they are betting on earning financial profits as silver prices rise and fall. They very seldom if ever deal in the underlying physical silver, it is just a pure paper game for them. The large speculators must report their evolving long and short positions to the CFTC on an ongoing basis.

The third class of futures traders is much smaller than the first two, the small speculators. Small speculators are often individual investors like you or me betting on price fluctuations in silver. We generally have no intention of taking delivery on a contract and we seek to bear risk just like the large speculators. Since small specs have tiny positions relative to the entire silver futures market, they do not have to report to the CFTC. Their collective weekly positions are inferred based on the positions of the hedgers and large specs.

Within each of these three classes various traders have long and short positions. If the total longs are offset against the total shorts held by one class, it shows a net position. For example, if small specs had 33k long contracts and 13k short contracts, their net position would be 20k long silver futures. In this case the majority of small spec contracts are long so they generally believe the silver price is going higher.

While the total number of longs and shorts is always equal, the composition of net positions shifts among the three trader classes. Charting these evolving net positions over time offers interesting insights into the psychology underlying each trader class.

Since open interest grows over time in a bull market, it is natural that net long and net short positions will grow as well. This chart is also garden-variety typical for net futures distributions in an ongoing bull market. Gold looks the same way. The net positions in all three classes tend to grow larger over time and form a giant horizontal wedge gradually expanding to the right until the bull ends.

The biggest point of contention on this chart is the growing net-short position of the hedgers, rendered in yellow. Many silver manipulation theses swirl around the perceived ability of these hedgers to cap or retard prices by piling on their short positions. Adherents to these theses fear silver prices are doomed to fall whenever hedger net shorts approach existing bull-to-date extremes.

But if open interest rises throughout this silver bull, and new longs and shorts are always equal, then it is inevitable that silver shorts will rise. They don't seem to seriously retard this bull though. Silver went from close to $4 to over $8 so far and hedger net shorts grew on balance the entire time. I know it seems counterintuitive, but the higher the silver price goes driving increased open interest, the more short positions the hedgers will pile on.

The key to understanding this behavior lies in the very word hedgers. Silver hedgers are involved in the physical silver industry in some way, such as miners. Mining is a very risky business and all kinds of things can go wrong. It is also very capital-intensive so miners cannot afford to have insufficient cashflows because their silver comes to market during one of the periodic silver pullbacks. Thus, silver miners sell futures today to lock in their selling prices tomorrow. They then deliver into these contracts to settle them as their silver production allows.

Now as an investor I loathe producer hedging. It not only protects silver miners from silver's downside in a correction, but it sells off silver's upside to speculators. Thus a hedged silver miner will not be able to fully reap the massive profits leverage to silver during one of the metal's bull-market uplegs. Investors don't want to own hedged silver miners during a secular bull market since they have sold away some of their upside profits gains.

But as an analyst, I do understand why hedgers lock in tomorrow's prices today. And if you examine the chart above carefully, they even do it fairly logically. Hedger net shorts are usually the greatest when silver is making a major interim high. Thus the hedgers, through selling futures today that they will deliver into to offset tomorrow, are doing a reasonably good job of selling at relatively high prices rather than low prices.

Just as hedgers having net-short positions are merely a normal part of a bull-market futures economy, so are speculators offsetting these hedgers with net longs. Total speculator longs also rise throughout a bull market as more speculators get interested and start chasing the gains. Looking at the behavior of large specs and small specs over time is quite interesting.

Large speculators, often hedge funds, should be the most astute traders in the market. They have lots of capital and experience to match it so they should be the elite leaders that small specs want to follow. Provocatively though, as a group these large specs tend to trade like mainstream momentum investors and not contrarians. They tend to be the most heavily long near major interim tops and the least long near major interim bottoms, the exact wrong times!

Obviously the best time to be heavily long is just after silver has corrected and the time to pare back longs is when silver is getting overbought to new interim highs. While there are certainly individual large specs who are elite contrarian traders who understand this well, as a herd they act pretty conventionally. When hedgers want to sell contracts near major interim tops to lock in their selling prices, it is the large specs that are providing most of the offsetting long trades.

Another silver fallacy, though not manipulation related, concerns small speculators. I can't tell you how many times I have heard, from mainstream stock-market investors, that there is an unsustainable mania in silver. Because silver investors talk about silver over the Internet, there is a perception that we have already bid it as high as it can go. But as the actual CoT data on small spec net longs charted above shows, small specs aren't even remotely excited about silver yet.

Since mid-2002, when silver traded near $5, the small spec net-long position has essentially been flatlined. For the past three years there is no evidence that small speculators are growing too enthusiastic about silver yet. Indeed, they actually seem bored and indifferent since their net-long exposure hasn't been rising even with an excellent uptrend in silver over the past couple of years. When a true mania arrives someday, small spec net longs will almost certainly skyrocket.

Well, if the silver futures open interest and CoT distribution among the three classes looks perfectly normal, that leaves one more avenue of potential silver capping via futures. It involves concentration ratios, and unlike the OI and CoT data discussed above I cannot dismiss this thesis outright. But thankfully, as you will see, the potential for short-term manipulation via concentration domination is steadily falling as open interest rises.

Concentration ratios reveal the percentage of open interest held by the largest traders in silver futures. These largest traders can be either hedgers or large speculators since these two groups are not broken out when it comes to computing concentration ratios. For this analysis I used net concentration ratios, or the concentration ratios after a given large trader's longs and shorts are offset. For example if one particular trader has 100 silver longs and 50 silver shorts, he is considered a net-long trader with 50 contracts.

To understand concentration ratios, we must first discuss how prices move in futures markets.

In order for the silver futures price to move, there must be a temporary supply and demand imbalance in silver futures. If someone wants to buy 10 silver futures contracts but only 3 are offered for sale at the prevailing price, then the market maker must raise the silver price until 7 more contracts are offered for sale. Once the price gets high enough so the order for 10 longs is matched by 10 shorts, the transaction takes place.

As long as silver futures supply and demand matches perfectly in time, the silver price will not move regardless of volume. If I want to sell 100 contracts of silver at the same moment you want to buy 100, the brokers will facilitate this transaction instantly without any price movements. The same applies even if 10k contracts are bought and sold at the same time by different parties, no price movements.

But what happens if a seller wants to sell 10k contracts immediately but all the buyers together only want 1k at the moment? The market maker faces a supply/demand imbalance. He has to start lowering the silver price until the buyers think the deal is good enough to want to buy 10k contracts in aggregate instead of their 1k at the original higher price. When the price falls low enough so futures demand meets the supply, the transaction will take place.

Since the futures price of silver is totally a function of the timing and size of buy and sell orders, large traders can temporarily manipulate prices if they have enough capital. If a single trader puts in a 10k sell order of silver futures, knowing that there won't be buyers who want 10k longs, it knows the price of silver will fall until enough buying interest materializes to absorb its full sell order. This is the most logical way for short-term silver manipulation to happen in the futures market.

The best available measure for the potential of large traders to dominate the smaller traders on the other side of their trades is the concentration ratio. It shows the percentage of open interest that the 4 and 8 largest reportable traders on the long and short sides control at any given time. The higher the concentration ratio on the short side, the higher the probability that large short sales won't be immediately absorbed by smaller and fragmented long traders without a temporary price drop.

Our final chart this week shows the net concentration ratios on both the long and short sides by the 4 and 8 largest silver futures traders over time. It offers all kinds of interesting insights both potentially supporting and opposing silver manipulation theses focusing on capital dominance by one side of the trade.

It is important to note that net concentration ratios in silver futures are universally falling as this bull market marches on. As more traders are attracted to the vast opportunities in silver, open interest rises. With more participants the amount of capital that it takes for the large traders to maintain high concentration ratios grows dramatically. The more traders involved in a market, the more the relative power of existing traders is diluted.

This being acknowledged, the shorts are still far more concentrated than the longs for this entire concentration downtrend. Back in mid-2002 the largest 8 traders with net-short positions controlled over 70% of the open interest compared to around 50% for the largest 8 net-long traders. Today the largest 8 net-short traders' influence has been cut in half to around 38%. But the 8 largest net longs have fallen even more, to 21%.

Thus today's net-short concentration is approaching twice that of net-long concentration among the largest silver traders. There are far fewer short traders than long traders and they are less fragmented, so it is much easier for one or more of them to place large sell orders than it is for the less-capitalized longs to group together and hit the markets with large buy orders. So the potential for short-term price manipulations via large sell orders that cannot be easily matched by longs certainly exists.

So is this lack of parity between long and short concentration odd? Does it threaten the ongoing silver bull?

I don't think a higher net-short concentration is odd at all. If you recall from the second chart above, the hedgers are the largest players on the net-short side during a bull market. There really aren't a lot of these hedgers, including mining companies, so they control a lot more capital than an average large or small speculator. If the number of hedgers is considerably less than the number of large specs and vastly less than the number of small specs, then it is only natural that the hedgers will have higher concentration ratios.

And since hedgers want to lock in selling prices for their future production, their primary focus in futures trading is selling silver futures to guarantee their own future selling prices. As hedgers are the smallest class in terms of the raw number of traders and the short side is their primary trade in a bull, it is only natural that net-short concentration ratios will be higher than the net longs.

And even if one or more large traders were trying to suppress the silver price, the very nature of the futures markets makes this a self-defeating proposition. Every contract a silver short sells has to be purchased by a long. So if long demand isn't out there, a silver short is limited in the amount of contracts it can sell. No silver trader, no matter how well capitalized, can sell unlimited contracts short since demand is finite.

In addition, a silver short who cannot deliver the physical metal eventually has to buy back its shorts to close the contracts. If a silver short dumps a large block of silver futures in the markets to temporarily drive down prices, sometime in the coming months it will create demand when it buys back these contracts that will drive prices back up. Even if these offsetting long purchases are spread over time unlike the one-time selling dump, the aggregate effect of long purchases will drive silver prices higher.

While higher net-short concentration ratios reveal the possibility of short-term attempts to hit the silver price, over the long term such attempts won't work in a zero-sum game like futures. Shorts have to be purchased by longs immediately and then to close these shorts in the future longs must be purchased driving up prices. In addition, over time the silver concentration ratios are falling indicating that the relative power the large traders wield is fading with wider silver participation.

In light of this totally normal silver futures CoT data, I don't think silver futures manipulation was the most likely cause of silver's malaise of late. I do have an alternative thesis that I explained in depth in the new September issue of our acclaimed Zeal Intelligence monthly newsletter for our subscribers. In this letter I also outlined some elite silver stocks that are likely to thrive when silver's bull market reasserts itself, probably in the coming months.

The bottom line is the bull-to-date silver futures CoT data looks normal for a commodities bull. Open interest is growing as silver prices rise. Hedgers are doing more hedging as the silver prices rise as well, locking in their silver prices for business reasons. This is all perfectly ordinary behavior and nothing unexpected.

The highest potential area for short-term price suppression exists in the concentration ratios, which the shorts still dominate. But even if this is happening, which is somewhat doubtful due to the way the futures markets work, the increasing open interest is slowly and steadily eroding the relative power of the largest traders in the markets. This will make large orders from them less effective at bullying prices temporarily than in recent years.

Silver, like all markets, will ultimately move on its own core underlying physical supply and demand fundamentals, not mere paper buying and selling in the futures markets. And these physical fundamentals remain dazzlingly bullish for silver.

Adam Hamilton, CPA
September 9, 2005

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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