silver- option writers nightmare looming

  1. 5,382 Posts.
    The latest from Ted Butler


    July 22, 2003

    Is This The Real Move?

    By Theodore Butler

    The sharp, one-day jump in silver certainly focussed everyone's attention. The obvious question - is it the start of the big move, or just another head fake caused by tech fund/Silver Manager manipulative COMEX trading?

    Before I answer, I want to remind you that I have a distinct advantage over most people in attempting to answer that question. I know that many of you won't get to see my answer in print for as long as 2 weeks from today, July 24. The advantage I have is knowing just how stupid I could look then. It's something I'd prefer to avoid. Besides, my answer is I don't know. But I have another answer, namely, that is not the best question. The best question is what to do about it?

    Fortunately, that's an easy question to answer. I admit, it could be a fake out, and silver investors could be disappointed, once again. If that happens, it happens. You've been through it before and it didn't kill you. It won't kill you if it happens again. But it will be devastating if it is the real move, and you intentionally have less than a full physical silver position on. Is the risk of being less than fully invested worth the cost of missing the big move loaded to the gills? It's one thing for someone not to buy or hold silver, if they haven't taken the time to study it. It's quite another thing to know the story and not to be in with both feet. Don't get cute and try to time the market with real silver. Remember - Dimes to the downside, dollars to the upside.

    I don't know if this is the real move, but it feels different than any recent move. For one thing, we came out of the gate fast, up 6% in a day. It could just have easily been 16%, or 60%. My point is that this was not a "normal" move, but perhaps a taste of what's to come. The only news I read was bearish, namely Kodak's slow film sales. Certainly, that didn't cause prices to jump. This confirms that silver moves on COMEX paper trading only. Shame on the CFTC for not seeing this.

    Nightmare on Silver Options Street?

    As I wrote last March, in "A Very Interesting Trade", there were large options transactions back then in COMEX silver call options. And there's been a lot more of these large call options recently. I'd like to point out that the traders who sell call options might find themselves in trouble as a result of recent price advances in silver. Selling call options is a major component of the entire short position. Traders sell options to earn the premium that the buyer pays for the option. The selling is done on a leveraged or margin basis, The vast majority of calls are naked. Very little real silver backs them up. Since over 95% of all call options expire worthless, the option sellers have had a field day, making money for many years on the COMEX, because the sellers get to keep the option premiums. In fact, it is a big reason why someone might manipulate the price of silver, just to capture the premiums that could be gained by keeping the price of silver stagnant. I'm talking many hundreds of millions of dollars over the years, hardly a minor incentive.

    As of the close of business, July 24, there were over 62,000 COMEX silver call option contracts open - meaning 62,000 call longs (or buyers) and 62,000 call shorts. That's the equivalent of 310 million ounces of silver. This is in addition to the 95,000 short (and long) futures contracts outstanding, or 475 million ounces. Yes, that means 785 million total ounces are held short as of today, more than 5 times total world visible inventories. Outrageous. But let's just focus on the 310 million ounces short in call options.

    The sudden jump in silver prices may have sent the silver call shorts into financial peril. Certainly, if silver prices climb from here, there could be catastrophic consequences for many call sellers. Here's why - to sell a call short, generally requires very little margin, especially for options that have a strike price above the market. These are termed, "out of the money" options, meaning that there is no intrinsic value. (For instance, a call option on silver with a $5.50 strike price won't be worth much with silver under $5.00 per ounce and would be considered, out of the money). As such, there is very little margin required for a call seller of these out of the money options, and generally very little risk, given how flat the price of silver has been for so long.

    The typical margin required to be deposited by a seller of one such out of the money silver call is $100. (I think exchange rules allow the margin to be as little as $10 per contract). If someone were to short 100 such option contracts, out of 62,000 open, the margin required to be deposited would only be $10,000, or even a lot, lot less. Each contract covers 5000 troy ounce of silver. In this example, 100 contracts involve 500,000 ounces of silver. The seller is obligated to the buyer for any amount over the strike price. In this example, if the price of silver jumped a dollar over the strike price, the seller would be obligated to deposit $500,000 with his clearing broker, if the seller didn't buy back his contract.

    We haven't moved a dollar in silver (yet), but we have moved a quick 30 cents or so. Just the move we have seen so far, has caused many margin calls to be issued to short option sellers. In the example of 100 contracts being short for $10,000 total margin deposit requirement, the margin requirement could easily now be $100,000 or much more, for many such 100 contract positions. It's hard for most traders to come up with such funds overnight, especially when unexpected. Certainly, higher silver prices from here would result in additional shocking margin calls.

    At some point, higher silver prices will break the back of many option sellers. Unable to come up with massive amounts of money for margin, there is only one other choice for the option sellers - buy silver in some form (futures or options) to stop the hemorrhaging. This is what happened in September 1999 in the COMEX gold market, when the Washington Agreement, limiting gold selling and leasing was announced. It was short covering from the gold call option seller that caused the price of gold to jump $80 very quickly. That same thing can and may occur in silver. If it does, it will happen quickly and exert a powerful upside boost to the price. If we go higher in silver from here, it could be a real nightmare for the silver call option sellers and boost the price of silver in a monumental manner.

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