Piling back into silver for the long haul

Note how open interest swells and peaks during silver rallies, and bottoms during the bottom of corrections. The reason for this is that the open interest on silver futures rises or falls with the amount of speculators in the market. For example, the recent sharp dropoff in open interest indicates that many long speculators were liquidating their positions, causing a sharp fall in the number of open contracts.

However, silver’s rally on Friday brought a renewed uptick in open interest, which we believe may mean a return of Managed Money to silver. As denoted by the white dotted line, the aggregate open interest in silver futures appears to be in a long-term uptrend, albeit with a bumpy ride along the way. We have been waiting for Managed Money to return to their previous high of net length, but the recent silver rally was fueled almost entirely by retail ETF and physical buyers. Managed Money’s prescience in staying away from the silver rally after September 2010 was uncanny, but we believe the long-term fundamentals of the silver market will eventually draw them back in.

Fundamentals

Ironically, while commodity markets sold off this week, bullish fundamentals for commodities actually strengthened. Jean-Claude Trichet’s dovish statements indicating that further rate increases were unlikely is further affirmation that developed economies have extremely limited ability to raise interest rates. The fact that even Trichet, the most hawkish developed economy central banker, is unwilling to raise rates more than nominally indicates the growth dilemma that the world’s major economies face: either maintain low interest rates, fuel speculative asset bubbles and fan inflation, or raise interest rates and risk renewed recession.

The US dollar’s recent weakness against the euro provided much of the last legs of the upward surge in commodities, but the unexpected US dollar rally on Thursday was too much for commodities to bear. The euro falling by 2% against the dollar unleashed the floodgates on selling by weak longs. However, going forward I firmly believe that both commodities as well as the dollar index will rally. While the dollar will continue to lose value against commodity and emerging currencies such as the Australian dollar, Canadian dollar, and Brazilian real, the dollar should do well against the euro, pound and yen due to the superior economic position of the US. In such a manner, the dollar as measured by the dollar index can rally along with strengthening commodity prices.

If further dollar index rallying causes more short-term pain for commodities, I would advocate being a heavy buyer of commodities, as fundamentals are only getting more bullish. As the market realizes that long-term fundamentals of commodities are unrelated to the dollar index, both can rally in tandem.

Trade Recommendation

We would recommend scaling into a long futures position in silver, as well as the sale of put options. However, due to the extreme volatility inherent in an ongoing correction, investors should not take out their full position at once, but instead be ready to buy more in case of further correction. We view $30/ounce as a hard floor on the price of silver, and the purchase of silver futures anywhere between 30-35 as an attractive long-term entry point.

As a trade, an investor could buy the July silver futures contract for 36.145 and sell the June 40 call for $1. The net effect of the trade would be an entry price on silver of $35.145. The $30 strike price puts should be sold on silver during corrections, going out as far as the December 2011 expiration. The purchase of bull call spreads can also be explored by traders who wish to gain greater upside leverage to silver prices.

We continue to favor investment in SLW as the premier silver equity. Due to the high implied volatility of SLW and recent massive underperformance of SLW compared with silver, we view the sale of put options against SLW as a highly attractive trade. The January 2012 $35 put options could be sold for $6.25, giving an investor the effective entry price of $28.75 for SLW stock. On a long-term basis, $28.75 is an excellent entry point for SLW stock, and the investor will profit handsomely if SLW is above $35 upon expiration.

Disclosure: I am long SLW, long silver futures, short silver put options

Additional disclosure: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.