How to "Play" a Parabolic Move in Silver (+2K Views)

Why Silver is Not in a Bubble Yet

In order to successfully identify bubbles and profit from them, one needs to know the tipping point at which a bubble [in this case a silver bubble] is unsustainable and begins to breakdown…This article focuses on just one of a myriad of factors that determine when a bubble may pop – momentum – and addresses what trading strategies may be suited to the situation. [Let me go on.] Words: 1475

So says www.skoptionstrading.com in an article* which Lorimer Wilson, editor of www.munKNEE.com,  has further edited ([  ]), abridged (…) and reformatted below  for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. The article goes on to say:

The Momentum Factor

• Psychologically: If investors are used to silver prices increasing 30% per year and then silver prices only increase at a rate of, say, 15% for one year, psychologically this return looks poor on a relative basis, even though it is still positive and normally would leave many investors satisfied. Therefore, there is a greater incentive to sell silver since it is not performing as well as it was in the past.
• Technically: Once a bubble is fully underway prices begin to rise in a parabolic or exponential fashion. If the price ceases to rise in an exponential fashion, selling will commence, even if the price is still rising, since investors will have extrapolated the exponential rise and so anything short of parabolic will not meet their expectations.

The most recent example of momentum was in the housing bubble. Prices didn’t actually have to fall at all to trigger a crash, all they had to do was plateau or rise sluggishly and this would spark selling by people who had bet on prices continuing to rise. Without continually rising prices real estate investors could not refinance and borrow more against their properties to buy additional properties or other assets, so the buying stopped and the selling began. This was when the bubble popped; this was the tipping point before the actual crash that many investors strive to identify.

How does the above relate to silver? Although we believe that silver does indeed have strong fundamentals, we do think it is likely that the metal will become drastically overvalued in the future as a result of speculative buying by the masses. In an attempt to measure the momentum behind silver and when this momentum will run out, we have analyzed the rate of silver prices increases over the last 50 years or so, since 1968. The chart below shows the rolling 100 day percentage change in the silver price. This is not a perfect measure of momentum, but it’s a start.

Why Silver is Not in a Bubble

As you can see, during the blow off in 1980, silver prices were increasing at a rate of roughly 400% per 100 trading days. This compares with a current rate of increase of approximately 73% per 100 trading days. So if you think silver’s current rally is going at a nose bleed pace, in the 1980 blow off silver prices were increasing 5.47 times faster than they are at the moment.

So far it appears that the rate of increase in silver prices at present is still below the relative rate of increase in 1980, therefore implying there is further upside. However this analysis doesn’t take into account that the Bunker-Hunt brothers were attempting to corner the market for physical silver in the late 70s, a buying force which is not present today. Therefore one should err on the side of caution when using this barometer for trading purposes as it may not reach 1980 levels. At present the barometer isn’t even close, so we do not think silver is in bubble at the moment.

The chart below best shows how silver is far from in a bubble yet. We have smoothed the 100 day percentage change and overlaid the nominal silver price.

As shown by the blue line still being relatively low in contrast with 1980, there is still a great deal of upside potential for not only the silver price itself, but the rate at which silver prices are increasing. When both the blue and red lines are parabolic, then a bubble argument can be made.

Some Suggestions on How to Invest in a Silver Bubble

As always the most important part of any discussion of the financial markets is how one should deploy one’s capital. Whilst a silver bubble is not yet upon us [one should consider one of the following approaches if, and when, such were to occur]:

• Take a short position: In our opinion this is not a particularly attractive trade. Whilst, of course, the investor will make money if silver prices fall, the investor is also open to unlimited liability on the upside and should silver prices continue to rise substantial losses could be incurred. Taking an outright short position via futures or short selling silver stocks implies that one believes that one’s timing is spot on. In reality nobody can ever have perfect timing so it makes sense to allow for some error in your judgement when placing the trade. This is important when placing any trade, but it is particularly crucial where bubbles are concerned since the market is moving in extreme ways. In the 1980 blow-off silver was increasing at a rate of over 100% per 30 days, anyone who was short would have got wiped out, just for being 30 days too early.
• Utilize options: Taking a position that would benefit from an imploding silver bubble offers much better risk-reward dynamics than being outright short.

There are two basic trades that we think would be attractive under an options scenario:

1. Allocate small amounts of capital to near term ‘out of the money’ puts: By purchasing puts that are, say, three months or less from expiration and at least 25% out of the money the investor is effectively buying insurance against a crash in silver prices. If silver prices plummet then the value of the puts will explode, but if prices keep soaring the downside is strictly limited to the premium paid for the put. If this trade is placed prematurely, it can be placed again in another few months, and again and again so long as the trader holds the view that silver prices are going to crash. If the view is correct then the eventual payoff will more than cover the cost of being too early in buying the initial puts.
2. Sell at the money call vertical spreads which are more than a year from expiration: This is a trade that expresses the view that prices are not sustainable in the longer term and therefore by the time the call options expire they will likely be worthless due the fall in silver prices. Additionally, if prices were spiking higher it is likely that call options would be being bought heavily by speculators, thereby inflating their premiums. By selling these call spreads one would benefit from a fall in silver prices and a reduction in call buying/increase in call selling by speculators over a longer term time period, without taking on unlimited risk.

We do not think either of the above trades are attractive at present. We are merely pointing out that they may be in the future if a bubble scenario does unfold.

Conclusion

During the blow off in 1980 silver was increasing at a rate of roughly 400% per 100 trading days compared with a current rate of increase of approximately 73% per 100 trading days, i.e. 5.47 times faster than presently. [Therefore,]  even if silver were to rise only half as fast as that of 1980, it could still rise twice as fast as it currently is before blowing off – so silver is far from in a bubble at the present time. [That being the case] we think it is the best, for now, to let silver run.

*http://www.skoptionstrading.com/updates/2011/4/26/think-silver-has-gone-parabolic-1980-was-5-times-faster.html