Monday, April 25, 2011

Are Precious Metals Overbought? Backwardation, Contango, and their Place in Levered ETFs

Are precious metals such as gold and silver overbought? In particular, silver's dramatic rise of over 25% in 10 trading days has given even the most bullish room for pause. Levered ETFs based on underlying gold and silver have risen even more dramatically and are currently trading in the mid-triple digits.

The key to determining mkt direction on the levered ETFs is determining whether or not the underlying is in contango or backwardation. This was the key to trading SKF, FAS, FAZ, and the other levered ETFs. It applies to both bull and bear etfs.

This is b/c no underlying - especially w/commodities - can ever offer a positive roll yield. Inverse etfs (aka the shorts) have a positive roll yield when the underlying is in contango. Bullish etfs on the other hand have a positive roll yield when the underlying is in backwardation.

Backwardation refers to a situation where the underlying's spot price is much more than the futures price. A perfect example is the commodities market now for grains (corn, wheat, soybeans). Contango refers to a situation where the future price of the underlying is more than the present. Perfect examples are Vix call options now and oil in 2009 when it was trading at $65/barrel.

A) Contango
Because the normal course of the underlying futures contract in a market in contango is to decline in price, an inverse fund composed of such contracts sells the contracts at the high price (going forward) and buys (closes) out later at the usually lower spot price.

This was the case of SKF, FXP, SRS and the other levered bear funds in late 2008-early 2009. Markets kept on closing consistently lower, week after week, month after month.

The opposite is true for bullish funds.

B) Backwardation

Because the normal course of the underlying futures contract in a market in backwardation is to increase in price, a bullish fund composed of such contracts sells the contracts at the high price (going forward) and buys (closes) out later at the (usually) lower price. But wait! I said usually. What if the underlying STILL remains in backwardation, month after month, expiration after expiration? The
underlying will continue to rise and in a levered etf it will take off like a rocket ship to the moon. This is why the silver 2x ETF, AGQ, is flying so high now.

As with any commodity, backwardation usually implies some shortage of physical supply. Not just a shortage. An extreme shortage.

C) Margin, Interest Rates, and CFTC Position Limits

Interest rates play a role too. When interest rates are low (like now) it becomes cheaper for funds to physically store and insure the metals.

Exchanges also periodically raise margin requirements when they think a commodity is getting too "hot". On the short side, we last saw this w/the inverse ETFs back in 2008-2009 during the SEC's notorious shorting ban (remember that? over 1000 stocks were deemed "financial companies"). We are seeing it this time on the bull side w/the CME raising margin requirements for oil, wheat, and corn. For precious metals, the CME has hiked margin requirements 4x already w/in the span of 1 year.

Nor is the USA alone in raising margin requirements. China also recently lifted margin on its own contracts in Shanghai by 3%.

Index funds and ETFs are the new, huge players on the commodities scene. Not hedgies and not investment banks. Everybody knows these massive funds' trading strategy: When a contract comes to expiration, they roll their contracts and buy long again (if bullish) or sell again (if bearish), regardless of what the price is. Under the
Dodd-Frank Act, position limits on derivatives are to be imposed by the CFTC.There have always been position limits in place. But they've not had either aggregate-month or all-month, or back-month limits. These ETFs and index funds are responsible for buying or selling (but more buying b/c bullish funds have more exposure and
capital) huge amounts and adding to volatility.


A fund's NAV, or net asset value, also plays a role in determining market direction. NAV is defined as the per-share dollar amount of the fund which is calculated by dividing the total value of all the securities in its portfolio, less any liabilities, by the number of fund shares outstanding. Levered ETFs frequently trade at a substantial premium or discount to their NAV value. Potential signs of overheating or cooling include double digit premiums.

E) Putting it all together

Sustained backwardation in any commodity is rare. It implies a physical shortage and thus a tremendous bull market. Silver is now in backwardation. Gold is leaning towards it but remains slightly neutral.

You can find out at a glance how slanted the backwardation or contango a commodity is by going to the CME's web site. This is silver's

I do not associate backwardation with possible topping, I associate STEEP backwardation with possible topping. When I notice a steep backwardation curve I don't have to get short immediately (but will definitely pay close attention other technicals )AND will wait the curve to flatten out in the direction of contango. This is a contrarian signal.

F) Implications for the Dollar

The danger signs to watch out for is if gold slips into as strong backwardation as silver. If it does, then its all over for the $. There is basically uncharted territory below 71 (summer 2008 lows - also when oil peaked at $145/barrel). This was the low on a 10 year chart (2001-2011).

If you think that the US govt is going to default or go into hyperinflation, then keep any gold or silver you already own. But I'm getting ready to bet the other way. The US will not turn into Zimbabwe w/in the next few months and will act to tighten monetary policy.

G) Conclusion

Any signs that the market is reverting to contango (when futures are more expensive than the spot price), COMBINED W/bearish technicals, should be a yellow light for bulls to cash out and a potential sign for bears to begin easing into a short position.
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