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This essay
will attempt to address the question of whether or not silver prices are in a
bubble, or possibly may be turning into a bubble and if so what trading
strategies may be suited to the situation. This article will hopefully
provide another string to the readers bow in attempting to identify bubbles
and being able to protect one’s portfolio and even potentially profit
from them. For the record, we feel it is prudent to state our view upfront:
We do not think silver is in a bubble at this point in time. However, we do
think that it is likely that it will become a bubble in the future, but we
cannot say when or at what price.
Asset price bubbles have occurred since the
beginning of financial markets and will continue to do so as long as there
remains a marketplace for assets to be traded. A key property of a bubble is
that is it near impossible to identify with certainty before it pops, but
once it does pop the bubble is apparently obvious to everyone. In our
opinion, only those who risk capital and profit betting against a bubble can
claim to have correctly identified one.
 
A casual glance at the chart could leave an
impression that history is going to repeat itself and silver prices are about
to crash. However in order to not only successfully indentify bubbles but
also profit from them, one will need to know the tipping point. This is the
point at which the bubble is unsustainable and begins to breakdown.
There are many factors which contribute to the
emergence of bubbles and one would need to look at a myriad of factors to
determine when a bubble may pop. We will focus on just one in this article,
momentum. In finance, momentum is the empirically observed tendency for
rising asset prices to continue to rise. We are attempting to gauge when
silver may run out of momentum and when this bull market will turn into a
bubble and ultimately pop.
Whilst some may consider it crude to study momentum
as opposed to fundamentals such as supply and demand, we feel that it is
vitally important from both a psychological and technical standpoint. 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 this 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.
So how does this 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.
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 of 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.
But 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.
As always the most important part of any discussion
of the financial markets is how one should deploy capital. Whilst a silver
bubble is not yet upon us, we are going to suggest some trading strategies
that could offer attractive risk-reward dynamics should a bubble scenario
unfold.
Many people would be inclined to take a short
position if they believed silver was drastically overvalued and in a bubble.
However 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.
However by utilizing options the trader can take a
position that will benefit from an imploding silver bubble but offers much
better risk-reward dynamics than being outright short. There are two basic
trades that we think would be attractive under such a scenario.
The first is allocating 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.
The second trade is a longer term trade that
involves selling at the money call vertical spreads which are more than a
year from expiration. This 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 these
trades are attractive at present, we are merely pointing out that they may be
in the future if a bubble scenario does unfold. For now we think it is a case
of not pulling on Superman’s cape so to speak and letting silver run.
If silver’s rise is going to be even half as fast as that of 1980 then
it could still rise twice as fast as it is at present before blowing off.
Sam Kirtley
SKkoptionstrading
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