Silver Short Squeeze
Adam Hamilton

Silver has suffered a miserable year so far, bludgeoned by gold's unprecedented selling anomaly.  The exceptional weakness in both metals was greatly exacerbated by futures speculators piling on short-side bets.  But with silver shorts hitting record extremes, a super-bullish short squeeze now looms.  Any rapid silver rally is likely to spook the highly-leveraged futures traders, sparking a massive stampede to cover.

Even greater short-squeeze potential exists in gold, as I discussed in an essay several weeks ago.  And gold is the dominating primary driver of silver prices.  Since silver's secular bull was born nearly a dozen years ago, silver has had a stellar 0.924 correlation r-square with gold.  Over 92% of all silver's daily price action in that long secular span was statistically explainable by gold's own!  This is very important today.

Futures speculators' total short positions in gold recently soared to wildly-outlying record highs.  The only way these radically excessive shorts can be closed is by buying offsetting longs, and the sheer quantities required are gargantuan.  And as the gold price surges on this heavy buying to cover, the silver price will follow it higher.  Gold short covering will likely provide the initial spark to ignite the silver short squeeze.

This silver buying is likely to spread like a wildfire in a bone-dry forest.  Silver's great volatility and incredible potential to soar has a seductive allure that's never stamped out.  There are hordes of investors and speculators waiting to buy, ready to pounce on any significant rally.  Even though silver's price was hammered down 39.0% at worst this year by late June, silver exhibited remarkable relative strength.

Gold plummeted 28.3% over that same span, the victim of levitating stock markets spawning a mass exodus out of the GLD gold ETF and gold-futures forced liquidations.  In normal major gold selloffs, silver often doubles gold's losses.  So only being down 3/8ths more than gold is impressive.  This was partially due to incredible resiliency in the flagship SLV silver ETF, which stock traders didn't abandon like GLD.

As of the middle of this week, the heavy differential selling pressure on GLD had bashed its holdings down 32.6% year-to-date!  That is a breathtaking record extreme, and those 440.3 metric tons of gold that its custodians had to sell to keep it tracking the yellow metal were the major cause of gold's 2013 selling anomaly.  Yet over this same span, SLV's holdings grew by 3.1%!  Yes you read that right, they rose.

Despite silver being kicked in the teeth this year, stock traders didn't sell as fast as silver was being sold in the futures market.  So SLV's custodians added 10.0m ounces of silver to its holdings in one of the white metal's worst years ever.  This amazing SLV bullish divergence shows major latent investor interest in silver remains.  So traders likely won't hesitate to flood back in as silver's short squeeze unfolds.

Like gold, futures speculators' total positions in silver are detailed every Friday afternoon in the Commodity Futures Trading Commission's famous Commitments of Traders report.  These are current to the preceding Tuesday, so the latest available data as this essay was published was July 30th's.  And it reveals the greatest potential for a massive short squeeze ever seen in silver's entire secular bull.

The CoT reports break futures traders down into three separate classes.  They are commercial hedgers, large speculators, and small speculators.  The commercials are businesses that actually consume or produce physical silver, so they use the futures markets simply to lock in future prices.  The speculators don't deal in physical silver at all, they are purely betting on where silver prices are heading to next.

Every futures contract has a buyer and a seller, a different trader on the long side and short side.  And futures are a zero-sum game.  Every dollar won by one trader is a direct dollar loss for the opposing counterparty.  Thus the total longs and shorts in silver are always perfectly equal.  But across the three classes of traders, net-long and net-short positions arise.  And these are what herald the short squeeze.

This first chart looks at the silver-futures net positions held by large speculators, small speculators, and commercial hedgers over the past 9 years or so.  The weekly silver price as of each Tuesday (the day that the CoT reflects positions) is superimposed.  Silver-futures speculators have waxed extremely bearish in 2013, which is certainly understandable.  But these guys' collective bets are a strong contrarian indicator.

Back in late June as silver plunged to its nauseating lows, futures speculators' bearishness peaked.  On the June 25th CoT, large speculators' net-long positions in silver futures plunged to 0.8k contracts.  This was their lowest level seen in 10.2 years, since April 2003 when silver traded around $4.50.  Just 7 weeks earlier, small specs' net longs had sunk to 0.8k as well.  This 11.5-year low was the worst of silver's bull.

Given silver's horrendous selloff this year, it is easy to understand why futures speculators were so pessimistic on the white metal.  It is human nature to feel the worst about the prospects for any price after an exceptional decline.  It is a natural tendency that all speculators must fight and eventually master if they're going to prove successful.  Futures speculators' net longs hit major lows after long silver selloffs.

But the fascinating thing is futures speculators are always wrong at these major lows.  Silver is bottoming right as they're paring back their long-side bets and ramping up their short-side bets on it.  Pick any major net-long low among silver speculators in this metal's entire secular bull, and silver surged or soared soon after.  I've highlighted major episodes of spec net-long lows above in blue, they are very bullish events.

Despite their reputation as sophisticated traders, futures speculators as a group are not contrarians who've conquered their greed and fear.  They are the most bearish at the worst possible time, right when silver is bottoming.  And if major lows in spec net longs are very bullish historically, how much more so are the bull-record-low net-long positions seen recently?  Silver is on the verge of a monster new upleg.

There is only one way out of net-long lows, buying silver futures.  After these events where sentiment gets excessively pessimistic, there is always a sharp mean reversion back up to normal levels.  And in the post-stock-panic years between 2009 and 2012, the average large- and small-spec net longs in silver futures were 28.1k and 14.2k contracts respectively.  Last Tuesday, they were still very low at 5.0k and 3.3k.

So for futures speculators merely to return to their recent secular averages, 34.1k contracts will have to be bought.  It doesn't matter one bit whether this is buying to cover shorts or buying to add longs, it has the same effect on the silver price.  Every silver futures contract represents 5000 ounces of silver, so we are talking about 170.4m ounces of futures buying simply to mean revert.  This is a huge amount of silver!

To put it into perspective, realize the mighty SLV silver ETF now holds 334.3m ounces in trust for stock traders.  From SLV's inception in April 2006, it took 4.5 years of buying to first reach this milestone.  Silver futures speculators need to buy over half this much silver in a matter of months (futures have expiration dates) just to return to normal levels!  170m ounces is over a fifth of 2012's global production near 770m.

And like all extremes in the markets, exceptionally-low net-long positions among silver futures often overshoot on mean reversions.  The farther into extreme fear the great sentiment pendulum is pulled, the higher the subsequent swing back through its arc carries it into extreme greed.  So I suspect we will almost certainly see speculator net-long positions well above their 2009-to-2012 averages by next spring.

Major lows in silver specs' net-long positions are very bullish, marking the birth of major new silver uplegs.  And generally the more extreme the low, the more bearish the silver sentiment, the bigger the resulting upleg.  And given futures' inherent short lifespan, these sentiment swings usually don't take much more than 6 months to unfold.  Such mean reversions have driven the mightiest uplegs of silver's bull.

While this net-long contrarian indicator is very valuable, it is illuminating to dig even deeper.  Silver speculators can get to low net-long levels by some combination of reducing their longs and increasing their shorts.  But only the latter is what breeds short squeezes.  While speculators aren't compelled to add long-side exposure as silver rallies (they want to), they absolutely have to cover their short-side bets.

So the greater the proportion of high short positions relative to low long positions that fuel a particular net-long low, the more bullish it is.  This next chart breaks down the total longs and shorts held by large and small futures speculators together over the same 9ish-year timespan.  And with total speculator silver shorts recently hitting a major new bull-record high, the latest net-long lows are explosively bullish for silver.

Back in late June as silver plunged towards $18.50, the total shorts held by futures speculators soared to 49.8k contracts!  This is an astounding number, easily silver's secular-bull record.  Our CoT data extends back to January 1999, well into the end of silver's last secular bear.  And over that entire 14.5-year span, the total short-side bets by futures speculators have never even approached these utterly incredible levels.

Since each contract controls 5000 ounces of silver, American futures speculators alone were short 249.2m ounces!  That is nearly a third of the silver produced by all the world's mines last year.  And all this silver has to be repurchased.  Shorting of course means selling something you don't own.  So futures speculators effectively borrowed to sell a quarter-billion ounces of silver that absolutely has to be repaid.

The only way for speculators to unwind futures short positions is by buying other contracts to offset their earlier sales.  To go short they sell futures contracts, then to close these trades they buy them back.  And this buying drives up silver's futures price exactly like new long-side buying.  So the massive shorts in silver futures guarantee proportional massive buying in the coming months to cover and close these bets.

There is no other possible outcome.  By definition, futures speculators can't produce silver to repay the silver they borrowed to sell short.  If they had silver mines, they would instead be classified as commercial hedgers.  So they have to buy in the futures market.  And defaulting on this silver debt is not an option.  The American futures markets have a long history of ensuring every last contract is honored and settled.

Futures trading, due to its high inherent leverage, is tightly regulated by both the brokerages themselves and the government.  In order to trade silver futures, all speculators have to deposit cash margin in their accounts.  Every minute of every trading day, the brokerages' computers monitor this to ensure it is sufficient to close traders' positions if necessary.  The brokerages are on the hook if traders can't pay!

Today every 5000-ounce COMEX silver-futures contract requires maintenance margins of $11,250.  But at this week's $19.50 silver, one contract controls $97,500 worth of silver.  This means silver futures traders can run leverage up to 8.7x.  While most don't run at minimum margin, many get close since that high inherent leverage is what makes futures so attractive.  If they bet right, their gains are gigantic.

But at 8.7x leverage, a mere 11.5% rally in silver wipes out 100% of the capital risked by short-selling futures speculators.  And silver is an exceptionally volatile metal, so big up days are fairly common when it is enjoying major uplegs.  Thus silver speculators who've sold contracts feel great pressure to buy to cover when silver starts rallying.  Each day they delay can result in large fractions of their capital vanishing.

This short covering feeding on itself is what ignites short squeezes.  There is always some small fraction of futures speculators running maximum leverage.  These weak hands are forced to cover, often by margin calls, soon after silver starts surging.  And their forced buying accelerates silver's climb, forcing an even larger group of speculators to cover.  They buy, silver goes higher, and a vicious circle forms.

This past week, total futures-speculator silver shorts were still 46.2k contracts.  To merely mean revert back down to the post-stock-panic average of 21.5k between 2009 and 2012, they will have to buy 24.7k contracts.  This is 123.7m ounces of silver, the equivalent of 3/8ths of SLV's entire holdings today!  And the faster silver rallies, the quicker this buying to cover will unfold.  Case in point, take a look at 2005.

Back in August 2005, total spec silver shorts soared to 45.2k contracts.  Even though silver only traded near $6.75 then, speculators were extremely bearish on the white metal.  These periodic episodes of exceptional pessimism often coincide with silver's summer seasonal lows.  Total longs were relatively low then too.  And high spec shorts plus low spec longs is very bullish, the breeding ground for major uplegs.

And silver indeed soon soared in one of its spectacular parabolic uplegs.  From that previous bull-record spec-short high, silver rocketed 124.0% higher over the next 8 months!  Much of the first half of that monster upleg was driven by futures-speculator short covering.  As silver kept forging new highs in the subsequent months, many other buyers flooded in to ride the momentum.  But short covering birthed that upleg.

It wouldn't surprise me one bit to see a similar massive silver upleg between now and this upcoming May.  Record speculator shorts require record futures buying to cover.  And as the incredible resiliency of SLV's holdings in this miserable year demonstrates, there are plenty of other investors and speculators lurking and eager to buy any convincing rally.  A 125% upleg from late June's low would catapult silver near $42 by May!

While shorts have to buy futures to cover, spec longs also mean revert higher out of lows in silver uplegs.  Silver's extreme volatility has always been a speculators' dream, so they are raring to buy new long-side contracts as silver surges.  So at the same time silver shorts mean revert lower, the silver longs are going to climb back up to at least their 2009-to-2012 average of 63.9k contracts.  That is another 9.3k of buying.

Add that 46.6m ounces of futures buying on the long side on top of the 123.7m of short covering, and silver has 170.3m ounces of almost-certain near-term demand coming from futures alone.  This of course matches the projection from the CoT net-long analysis above.  Again this is over a fifth of total annual worldwide mining production, all marginal new demand on top of all the normal and usual demand.

And that is due to pick up dramatically in the coming months.  Gold and therefore silver have always had strong seasonal tendencies to see large investment-demand spikes emerge in autumn.  Asian demand for gold is always big, and unlike dumb Americans these smart investors love buying low.  Given gold's brutal plunge this year, Asian investment demand in the upcoming strong season should be enormous.

And provocatively silver should see a much larger proportion of these capital inflows than usual.  The goofy government of India has been waging a long war against gold.  Indians import vast quantities of it every year, which contributes to that country's trade deficit.  So the Indian government keeps trying to magically eradicate a many-centuries-old cultural affinity for gold through ever-escalating import duties on it.

But excessive taxation doesn't quell demand, it just forces it underground so these taxes are evaded.  So gold smuggling is naturally soaring in India.  But a fascinating side effect is there are more and more anecdotal reports of surging Indian demand for silver as an alternative.  Any significant new Asian silver buying on top of global futures buying, ETF investment, and physical buying will act like rocket fuel.

So silver is poised for a monster upleg in the coming months, initially fueled by a massive short squeeze in the American futures market.  If you aren't yet sufficiently invested in silver and silver stocks, you still have a small window to buy near 2013's exceptional lows.  Silver stocks in particular have plummeted to levels radically lower than even $20 silver justifies.  Their upside potential in this new silver upleg is vast.

Periodically at Zeal we spend several months digging deep into the world's publicly-traded silver stocks, to ferret out the elite with the best fundamental prospects.  Our dozen favorites are profiled in depth in fascinating and comprehensive reports.  Our last silver-stock reports were published late last year, and are now priced at just $35.  Buy yours today and get deployed!  Silver-stock gains far outpace silver's in its great uplegs.

We'll certainly be following the unfolding silver short squeeze and upleg in our acclaimed weekly and monthly subscription newsletters.  In them I draw on our decades of hard-won experience, knowledge, wisdom, and ongoing research to explain what is happening in the markets, why, and how to trade them with specific stocks as opportunities arise.  Subscribe today and gain a valuable contrarian perspective!

The bottom line is speculators' short positions in silver futures recently soared to record highs.  This group of traders has a long history of hitting peak bearishness when silver hits deep lows just as major new uplegs are being born.  Their bets are a powerful contrarian indicator.  And the only way they can exit their gargantuan silver short position is by buying a proportionally massive amount of silver futures.

This guaranteed buying will drive silver higher, putting great pressure on all the short speculators.  They will have to buy to cover, forcing silver higher and igniting a vicious circle.  A mere mean reversion of their total short and long positions to post-stock-panic norms would necessitate near-future buying equivalent to over a fifth of total global production!  That is great fodder to fuel an epic short squeeze.

Adam Hamilton, CPA

August 9, 2013

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