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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 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 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. 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. Our premium options trading service, SK
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