After rocketing 76% higher in just 5 months, silver continues to enthrall investors and speculators. In the decade I’ve been gaming its bull through actively trading silver stocks, I’ve never seen this metal so popular. As more traders discover silver and start following and trading it, I’ve heard a lot of questions on a recent development in the silver-futures market. Its open interest recently declined sharply.
Specializing in stock trading myself, I don’t delve into the futures world very often. I haven’t written about silver futures since 2005. Mostly this is because years of research, study, and trading experience have shown me that silver futures usually aren’t particularly relevant to silver price action. Silver’s primary driver is actually the price of gold, so if you want to trade the silver complex successfully watching gold is the key.
Not only does silver-futures action fail to help me profitably trade silver stocks, it has long been ground zero for conspiracy theorists. While not as prevalent today, back in the early 2000s some newsletter writers made a cottage industry out of promoting endless silver conspiracy theories. I witnessed countless traders get bogged down in and derailed by this contradictory and ever-changing mythology. The end result was often deep paranoia that crowded out rationality, crippling their ability to profitably trade silver.
The modus operandi of the most-prolific silver conspiracy theorists was similar. They spent endless hours analyzing and attempting to draw conclusions from an arcane government report. Since this report is so technical and difficult for laymen to understand, they acted like high priests ferreting out its secrets. Their assertions started with facts from the report, but ended with opinions. Their followers eagerly hung on every word, trying to expose the vast conspiracy that prevented them from getting rich in silver overnight.
Published every week by the US government’s Commodity Futures Trading Commission, this cryptic document is known as the Commitments of Traders report. Go download one and see what a nightmare it is! There are currently over 60 different versions of this one report published weekly, covering different futures contracts and exchanges. Each futures contract has 10 to 14 columns of data spread across 4 to 13 rows, depending on the format and what is included. They definitely aren’t easy to interpret.
To an average individual investor who hasn’t spent dozens of hours getting up to speed on the CoT, it may as well be ancient Greek. Adding to its mystique, prior to 1995 it was only available by paid subscription. So newsletter writers would buy this arcane report that most people didn’t have access to, try to divine its mysteries, and formulate seemingly highly-intellectual trading strategies based on it. And in truth, a small fraction of futures traders probably really can use the CoT to help generate profitable trades.
Most CoT analysis centers around one of three threads. The first is open interest, or how many futures contracts for a particular commodity are open and outstanding at a particular time. The second is the distribution of these futures, how they are spread between three different classes of traders. And last is concentration ratios, which reveal the percentage of all open contracts held by some of the largest traders.
Open interest is the easiest to analyze, and in silver’s case is what is concerning some investors and speculators today. It counts the total silver contracts in existence. Each silver futures contract represents 5000 troy ounces of silver. At $25 to $30 silver, this puts the notional value of each contract at $125k to $150k. In order to control this much silver, a futures trader only has to put up $6500 in margin money!
This extreme leverage, along with the ability to directly trade commodities that can’t be traded in the stock markets, is the primary allure of the futures markets to speculators. Controlling $125k worth of silver with just $6.5k in capital represents leverage of 19 to 1. By law, margins for stock traders can’t exceed 2 to 1! This makes futures an extraordinarily high-risk high-reward environment for traders running at the minimum margin. At $25 silver, a 5% move either way would either double their capital or wipe them out!
Open interest reveals how many silver contracts futures traders currently own. When it falls dramatically, like it did in silver in November and December after the CME Group raised silver-futures margins by 30%, traders get nervous. Futures traders as a group are rightly considered more sophisticated than stock traders as a group. So when futures traders start liquidating positions rapidly, stock traders who pay attention to this stuff start to get concerned. What do the futures guys know?
Silver-futures open interest has actually been in a strong secular uptrend over the past decade. In any secular bull, the longer a price powers higher the more traders discover it and deploy their own capital to partake in the gains. This uptrend has been remarkably consistent, with only a few extra-trend episodes. Open interest shot up on big silver surges in late 2005 and early 2008. Nothing attracts in new traders like fast-rising prices hitting new multi-decade highs, everyone wants to chase a winner.
But those breakout surges didn’t last, silver had soared too high too fast for those levels to be sustainable. As soon as its near-parabolic uplegs collapsed, so did open interest. Silver is an extraordinarily-volatile and unforgiving metal even without using leverage, corrections of a third in less than 6 weeks are par for the course. You can imagine how devastating a 30%+ plunge is for long futures traders running 10+ to 1 leverage! Many are wiped out when silver corrects.
The only time silver-futures open interest fell below trend was during the brutal 2008 stock panic. In addition to being driven by gold, silver is highly sensitive to general-stock-market action. Between July and November 2008, silver plummeted a jaw-dropping 53.4% before bottoming on the very day the S&P 500 did! Again this obliterated leveraged silver longs and reduced the survivors’ appetite for risky silver futures for a spell.
But as silver rapidly recovered after the stock panic, so did traders’ desire to own silver futures. Their open interest was back within the old secular uptrend by late 2009. In 2010 they were flat for most of the year until silver started rocketing higher in its massive autumn rally. But interestingly there was no upside breakout in open interest this time, unlike in the last major silver uplegs it merely edged up to resistance.
I remember some CoT watchers being concerned about this in November. At silver’s latest peak, only about 159k contracts were outstanding. This compares to a staggering 189k in February 2008 and a comparable 150k in November 2005. Was something wrong with silver last autumn since fewer bets were being placed on it by the futures guys? Not so you’d notice, as silver continued powering to new 30-year highs for 2 months after the recent open-interest peak.
November 2010’s lower open-interest peak never seemed like a big deal to me. It was right up near secular resistance, silver-futures trading is still growing on balance as this silver bull matures. If the peak had happened well below support maybe that would be worth some anxiety, but a resistance approach in a strong uptrend is very healthy and bullish. More interestingly, consider the big expansion in notional value that each contract represents as silver powers to new bull highs.
Each silver contract has represented 5000 ounces throughout this metal’s entire bull. So a contract at the November 2005 open-interest peak when silver traded under $8 was worth far less than one in November 2010 when silver approached $25. To adjust for this, I labeled the last four major open-interest peaks with the total notional value based on the silver price and contracts outstanding. Even though one could argue open interest has largely been consolidating since 2005, far more capital is involved today.
Back in November 2005, the notional value of silver futures outstanding ran about $5.8b. And 5 years later in November 2010, roughly the same open interest represented a vastly-larger $19.7b worth of silver. So despite open interest being more or less flat between these peaks, futures traders are playing with about 3.4x more capital today. Notional capital is really important to consider in a secular bull market, not just raw open interest with no regard for how much each contract is worth.
Another interesting aside is the wildly-popular physical-silver ETF, SLV, was launched in April 2006. I just wrote a new essay on this silver behemoth a couple weeks ago. Since SLV gave stock traders their first-ever way to bet directly (including through options) on silver prices, there is a good chance that some capital that would have been run through silver futures has been diverted into SLV. I wouldn’t read too much into this though, as SLV does not have the extreme leverage that makes futures attractive to many.
And this brings us to the impetus for this essay, the large 18.0% plunge in silver-futures open interest between November 2nd and December 14th. Is this worth worrying about? I don’t think so. Note above that despite this retreat, which was partially driven by the margin increase on November 9th, open interest remained well within its secular uptrend. We’ve seen this metric fall sharply from resistance to support many times in this bull, yet silver still continued marching higher on balance. This latest swoon was merely a garden-variety liquidation of silver futures, nothing special at all.
In addition to reporting open interest on a weekly basis, the CoT divides futures traders into three classes. Commercial hedgers are the main one, these are entities that are theoretically actually producing or consuming the underlying commodity a futures contract represents. Think of a silver miner that needs to lock in its silver selling price in the futures market in order to secure a bank loan, or a factory that needs to guarantee its silver purchasing price to control its input costs.
The remaining two classes are speculators, who are not actually producing or consuming but merely want to bet on price action to earn a buck. They are subdivided into large speculators, traders with big-enough positions that they have to report them to the CFTC, and small speculators who don’t have to report. The most popular thread of CoT analysis examines the aggregate bet each of these groups is making.
Every individual futures contract has a long side and a short side. The long party bets a price will rise while the short party simultaneously bets the same price will fall. Thus the total number of longs and shorts is always perfectly equal. Futures are a pure zero-sum game, every dollar one side of a futures contract wins is a direct dollar lost from the counterparty on the other side. But within the three classes of traders, aggregate net-long and net-short positions develop.
In a secular bull, it makes perfect sense for speculators to generally be net long while commercial hedgers are generally net short. When a price rises on balance for years, and its global supply-and-demand fundamentals remain bullish, speculators bet that this bull run will persist. Meanwhile hedgers, primarily silver producers, like to lock in their selling prices to protect their cashflow streams from silver’s incredible natural volatility. The classes’ positions above relative to the flat line are totally normal.
But it is provocative that since late 2004 the net bias of each class has been relentlessly shrinking. Even though open interest is rising, more silver futures contracts are being purchased, the directionality of bets within each class is less coherent and one-sided. More speculators are taking the short side of trades, gaming silver’s brutal corrections. And more hedgers are taking the long side, probably mainly the industrial silver consumers.
Nevertheless, just like in open interest the rapidly-rising notional value of each silver contract must be considered here. When large speculators’ net-long contracts peaked in December 2004, they represented about $2.8b worth of silver. Yet by September 2010, despite a much-smaller net-long position in this class, its notional value had soared by 2.3x to $6.4b. The same is true for small speculators. Despite shrinking net positions, the capital speculating on silver futures is really growing.
Hedgers’ net shorts have seen a similar phenomenon. Though their net-short balance has been shrinking, it has still nearly doubled from $3.6b worth of silver in late 2004 to $7.0b last autumn. I wonder if SLV’s launch led to more hedgers (consumers) taking long positions in silver futures. Silver’s industrial users lobbied the SEC aggressively to deny SLV approval, because they feared the flood of capital into silver would drive up its price. They were right. So industrial users have likely been increasingly locking in their silver purchasing prices by buying long futures. This would reduce hedger net shorts.
While the class distribution of silver futures is interesting, after watching it every week for a decade I really don’t think it is particularly useful. As a zero-sum game, every single short has an offsetting long and vice versa. So when commercials got to record net shorts, which used to drive conspiracy theorists into a rage, it also meant speculators grew to record net longs. Each silver contract is matched and neutral, so the notorious shorting boogeymen can’t add shorts unless other traders voluntarily buy offsetting longs.
In addition, the class lines are blurry and arbitrary. A silver-futures trader like a miner or small investor clearly falls into its appropriate class. But what about an aggregator like a major bank that has many different clients? If its futures are held in the bank’s street name, should it be classified as a hedger or large speculator? What if 60% of the futures trades it has on are for mining clients and 20% for hedge funds one quarter, but the opposite the next? How is this bank classified? The more I learn about the CoT, the less I trust the way its classes are drawn.
This same problem, how to classify traders that aggregate their own clients’ trades, is the primary reason the third thread of CoT research is also pretty pointless. Concentration ratios reveal what percentage of open interest (long and short) is currently held by the largest 4 and 8 traders. For an entire decade, conspiracy theorists have been going apoplectic screaming about how these ratios must prove their manipulation mythologies. Zero-sum game be damned!
But concentration is meaningless if large single traders are aggregators. If a bank trades futures for 1000 clients, but that bank is counted as a single trader because it holds its clients’ futures in its street name, is its attribution as a large trader really meaningful? I certainly don’t think so. And when you look at long-term charts of concentration ratios in silver futures and other commodities, they really don’t change a great deal. Large traders will always hold a large fraction of outstanding futures, no surprise. Futures have always been the realm of the big sophisticated players, not small traders.
So personally, I don’t find the CoT very useful for trading silver. The flowing and ebbing of the various numbers it reports don’t consistently correlate with silver uplegs and corrections, so it isn’t very useful for timing silver’s major moves. And since it is only published once a week, and delayed, it doesn’t offer a high-resolution real-time read on the state of silver futures. This is a government report that’s been around in one form or another since 1924, most of its conventions are from a bygone era and don’t adequately reflect modern global markets.
While I do realize some traders are able to mine the CoT for useful data, it hasn’t helped me despite many years of studying it. The CoT reflects reactions to silver-price moves sparked by other drivers, primarily gold and the general stock markets, not causes. And if any particular information set doesn’t help time entries and exits that lead to profitable trades, it is no more than peripheral trivia for investors and speculators. Our finite time is better used in studying the real primary drivers of prices like silver.
And I can’t even count the number of investors and speculators I have heard from in the last decade who got all hung up over the CoT due to some nonsense-du-jour some wacky conspiracy theorist was babbling about. This report is misused and abused constantly. So unless you find someone with a public, proven, and profitable track record trading silver futures based on their analysis of the CoT, I would be very wary of putting too much faith in it. It’s a minefield that seems to confuse more than enlighten.
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The bottom line is nothing looks strange in silver futures per the Commitments of Traders report. Open interest has declined, but it remains well within its secular uptrend. And the rising silver price has multiplied the notional value of silver traded in the futures market, despite open interest failing to make new highs last autumn. The net positions of the trader classes are shrinking too, but this trend has been in place for over 6 years now (since silver was around $8). It’s nothing new.
While silver futures will always be an important part of the silver market, traders have to remember they are a zero-sum game. Every short has an offsetting long, and vice versa. It’s easy to get bogged down and derailed in the CoT, giving this report more credit than it deserves. Its trader classes aren’t accurate and it doesn’t consistently signal major interim highs and lows in silver. It’s more of a curiosity than a tool.
Adam Hamilton, CPA
January 28, 2011
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