Page 1 of 2 SPEAKING FREELY Back to basis for silver By Antal E Fekete
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When people are told that huge quantities of commodities are bought and sold
every day without any reference to the price, the reception is invariably
incredulous silence. It appears incredible to the uninitiated that the price
risk can be neatly side-stepped.
The uninitiated have to be told that when the professional grain trader gives
an order to buy or sell corn, he may be unaware whether the price of corn is up
or down. He doesn’t care. He is
buying and selling hedged corn, and he takes his clues from the basis, not the
price of corn itself.
He has replaced price risk with basis risk, which he knows how to handle as its
behavior is less erratic and more predictable. Most people don’t realize that
the bulk of grain trading on the futures markets is driven not by the price but
by the basis. In the grain market, by basis is meant the difference between the
futures price and the local cash price of the grain. Thus the basis varies from
place to place, and from one delivery month to another.
Trading the basis means buying or selling hedged grain. The merchant goes long
on the basis by purchasing hedged grain when the basis is wide, and selling it
when the basis is narrow (possibly negative). He goes short on the basis by
selling hedged grain first when the basis is narrow (possibly negative), and
selling it later when the basis is wide.
The myth of naked shorts
The silver market is similar. Large quantities of silver are bought and sold
every day without reference to the price. Professionals trade hedged silver on
clues from the silver basis. They are not gambling on the price variation of
silver: they want to earn a reliable income on physical silver already in
store. They may do this on their own account or, more typically, on customer
account. The ever growing inordinate and concentrated naked short position in
the face of a strongly rising price is a myth.
Silver basis is the difference between the nearest futures price and the cash
price of silver. It is puerile to assume that most professional traders are
naked short in silver, just as it would be sheer ignorance to suggest that most
professional traders of grain are naked short in corn. They are not. You may
rest assured that their corn is well in place in a grain elevator somewhere. If
the elevator is registered with the commodity exchange, then the hedger may
post a reduced margin on his position. But the elevator need not be registered,
in which case the hedger posts full margin.
While this is not typical in the grain trade, it is quite common in the silver
trade. Rightly of wrongly, the silver trade is surrounded with far more secrecy
than the grain trade. This has to do with the fact that silver is considered a
monetary commodity by many in the first place, and an industrial commodity only
in the second. We must understand that lots of people are accumulating silver
not so much for the ride to US$1,000, which may or may not happen, but in
protest against low interest rates on passbook savings and certificates of
deposit.
They are happy to post full margin instead of the lower hedge margin on their
short position in silver in exchange for anonymity. Of course, the exchange
knows that theirs is a hedge position, but must treat this information as
confidential. So must the US government's Commodity Futures Trading Commission
(CFTC).
Let’s start by reviewing the differences between the grain and silver trade. As
most grain is sold to the ultimate consumer within the year of production, the
basis has a yearly cycle with trough just before and peak just after harvest.
By contrast, the silver basis is not cyclic. Silver is typically accumulated
year after year by investors and bullion banks.
Instead of an annual cycle following the crop year, the silver basis has a
long-term falling trend, a strong hint of a slowly developing shortage. It is
impossible to predict when shortage will hit. After every major price advance
there is profit-taking by unhedged investors, and after every major price
decline there is short covering by hedged investors and bullion banks. Net
selling through profit-taking and net buying through short covering may or may
not balance out. Accordingly, the trend towards a permanent silver shortage is
going to be uneven.
Historical sketch of the grain trade
Farmers produce billions of bushels of grain every year. Most of this grain is
sold several times in the futures markets as part of the basis-trading before
it is consumed. An understanding of the historical development of the futures
markets may be helpful.
Standardized futures contracts began trading on commodity exchanges in the late
1800s. Futures markets revolutionized the way cash grain was traded and gave
the grain elevators and the farmers the ability to buy and sell more easily and
profitably. Grain companies learned how to use futures contracts more
effectively to manage risks, and to maximize income from their elevators. The
big revolution was the advent of basis-trading, to replace price-trading.
This revolution is not mentioned in school curricula; not even in university
curricula. This is a pity. The story of basis trading is a story of capitalism
triumphant. It teaches how the free market can overcome the capriciousness of
nature. As more people learn the skills of basis trading, profitability grows
and business expands.
The grain business prospered until the 1930s, when the Great Depression began
and governments became heavily involved in grain trading. Government programs
dominated the marketplace. Storage of grain was encouraged and construction of
new elevators was subsidized. However, the market was stagnant, to a large
extent precisely because the new elevator space was taken up by
government-owned grain. This grain was just sitting there in the elevators
until it was ultimately given away to other governments or to charities.
In the 1970s governments decided to reduce their presence in the grain market.
A new era started when market forces were allowed to prevail once more. The
grain business re-learnt how to increase efficiency, manage risks, and generate
income through basis trading. Generally, the abundance of grain kept the market
stable. Under these conditions the opportunity for trading was confined to
buying and holding grain. This is known as the "carry trade": buying when the
basis is at its highest and selling when it is at its lowest. The basis was
following a consistent pattern and as it declined from harvest to the end of
the crop-year, the grain trade was provided with a reliable income.
It would take a sizeable drop in production to cause any significant move in
the price and a deviation of the basis from the customary pattern. While it did
not happen very often, the market came away with flying colors, proving the
superiority of trading the basis over trading the price, especially under
volatile conditions.
The 21st century brought new challenges to the grain trade. The market became
demand-driven. Increasing population and improved living standards around the
world opened up markets to more people and boosted demand for processed food
and other consumer products. There has been a tremendous growth during this
first decade of the century. In addition to the carry trade, "value-added
trade" has put in an appearance and started growing.
In this environment, grain does not sit around in elevators for a long period
of time. The market absorbs it and makes it into all kinds of products for
human and animal consumption. Most recently, grain has started trading also for
use in energy production. All these changes contributed positively to basis
trading as it has changed the dynamics of the marketplace.
Of course, not all grain traders are trading basis. A dwindling number still
trade price. Most of these traders are barely surviving. They will have to
learn the skills of basis trading or perish. It is a safe bet that no new grain
elevator is being built with trading the price in mind. They are built with
trading the basis in mind. Those who are still trading price are missing one of
the great opportunities of the century by not understanding basis.
Historical sketch of the silver trade
Second only to gold, silver is a monetary metal. This means that above-ground
silver represents several years' output of the mines. One should not be misled
by the propaganda line that this silver "has been consumed by industrial
applications". The recovery of scrap silver is a function of the price. As the
price of silver rises, the rate of recovery will rise with it, sometimes
dramatically.
In addition, an unknown but substantial amount of silver still exists in
monetary form. Owners do not want to reveal their identity, or the size of
their hoard. But this does not mean that monetary silver has disappeared in
consumption. There is no support for the claim that silver is in short supply,
or that silver has ceased to be a monetary metal. Any apparent shortage simply
means that the carry trade holds back stocks from the market in hope of an
early price advance. At the right price it will make the metal available.
Prior to 1873, the price of silver was stabilized through monetary legislation
at US$1.29 per ounce. After the Civil War, the US Mint was closed to silver.
The German government also closed its Mint to silver in the wake of the
Prussian victory over France at about the same time. Silver was dumped in the
markets in unprecedented amounts, driving the price down to as low as 70 cents
by the end of the 19th century. Although the price spiked back to $1.29 at the
end of World War I, it did not last and during the Great Depression it hit a
low of 25 cents.
We may add that upheavals in the silver market were a direct consequence of
government meddling. Ultimately people have learnt how to neutralize the
destructive influence of the government in an effort to control money, and they
borrowed a leaf from grain merchandising manuals in trading the silver basis.
Through all this time up to 1965, there was no silver trading on the organized
commodity exchanges for reasons of insufficient volatility. By 1965, the world
market price threatened to exceed the statutory price, as demonstrated by the
disappearance of silver coinage from circulation, and volatility perked up.
Silver trading on the organized commodity exchanges started. However, secrecy
continued to surround the silver trade as one monetary crises followed another
at more or less regular intervals. There was a conception that silver could
also be confiscated, as gold was in 1933. In the event, the ban on gold
ownership and trading was lifted in the US at the end of 1975, allowing gold
futures trading to start and giving a boost to silver futures trading already
in progress.
Secrecy prevailed and manuals on how to trade basis in the gold and silver
markets were never made public. Those anxious to learn basis trading of the
monetary metals had to buy the manuals for basis trading in grains, and work it
out for silver and gold on their own.
This is not as easy as as it sounds, because of pitfalls due to the fact that
trading monetary metals differs from trading grains in almost every respect.
Having said that, there is no question that basis trading in gold and silver is
a wide-spread practice preferred by the most conservative investors, and even
the more venturesome cannot do without at least a rudimentary understanding of
the underlying principles.
We have mentioned above that trading the basis for grain instead of trading the
price was a triumph of capitalism. Man has learned how to overcome the
capriciousness of nature. The same also happened in the silver market: trading
the silver basis increasingly replaced the trading of the silver price. The
difference is that here it was not the capriciousness of nature but the
capriciousness of governments that was overcome. Governments want you to
believe that they can create and destroy value at will by monetizing debt while
demonetizing silver and gold. In effect they cannot do either in a durable way.
Government magic goes only so far as gullibility of the people.
The last contango in Washington
Volatility in the gold and silver markets is like a dormant volcano.
Unannounced, it erupts periodically with increasing ferocity. As it does,
trading the gold and silver price is becoming ever more treacherous. There can
be no doubt that the answer is basis trading, that is, buying and selling
hedged gold and silver. It is only a matter of time before a trading house or
bullion bank will offer this service.
The significance of the silver and gold basis can be found in the role they
play as an early warning system. Under normal circumstances backwardation in
gold and silver is an aberration. Monetary metals must be sufficiently
plentiful in order to serve as such. This translates into contango. But at the
time of monetary disturbances, like the one triggered by the subprime mortgage
crisis, the monetary metals tend to go into hiding. As they do, the cash price
goes to a premium against futures prices, and the basis goes negative,
indicating the extent of scarcity. If hyperinflation is in store, gold will go
into permanent backwardation, foreshadowed by a steep decline in the
basis.
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