Discovery of the silver spot price is a by-product of trading silver futures at commodity exchanges around the world.
Understanding where the silver spot price originates is important because
silver bullion dealers use it as a reference point to price their products. It also helps us better understand a root cause of volatile silver prices.
Silver Futures Speculators Add Value
Short hedgers, like the silver solder company found here, want to minimize the negative impact of falling silver prices on their profit margins by selling silver futures.
Therefore, the solder maker needs speculators to buy its silver futures to hedge the physical silver it purchased to make products.
Speculators who buy silver futures and believe silver prices will increase over time provide liquidity for short hedgers like the solder company above.
A silver products manufacturer might also take a long hedge position and buy silver futures if it expects silver prices will rise.
A long hedge assures the company that its silver cost of ownership will not increase because of rising silver prices.
An investor with an open long position is a buyer. A seller is someone with an open short position.
Open indicates an agreement was made but has not been completed, settled or offset by another contract. An open position can last a matter of moments, minutes or months.
Profiting From Falling Silver Prices
How do speculators make a profit when silver prices fall? A speculator who agrees to sell (short) silver at a future date believes silver prices are going to drop.
The trader who commits to buy the silver from the speculator at that future date accepts the long position and the view prices will increase.
If silver prices fall during the interim, the speculator agrees to a long position with another party offsetting his/her short position.
Consequently, the speculator earns a profit upon exiting the short obligation since the offsetting contract cost is less.
Speculators play an important role. They are needed in the silver futures marketplace because they provide liquidity for other traders. Silver speculators also help other investors mitigate risks (see grey box below).
Taking long positions while silver prices are falling provides liquidity for traders who want to short their positions to limit losses. Buying activity can also help stabilize falling prices.
Jump to the Speculator and the Hedger Section to read an example of a generic silver futures transaction.
Many believe a small number of very large banking institutions cause silver spot price suppression by selling (short) high volumes of silver futures contracts.
Only a small percentage of contracts are carried through to completion since short open positions can be liquidated without delivering silver bullion -- which is why silver futures are also called paper silver.
Therefore, high volumes of shorts from a few institutional traders can create the perception that a surplus of silver exists. And the result is an artificially low silver spot price.
In reality, the actual supply of physical silver is more limited than the perception in the paper silver scenario.
I’m not claiming that suppressed or inflated prices (discussed below) are conspiracy driven. But instead, they are natural consequences if you consider the nature of the beast (futures marketplace) in its current form.
Lax Margin Requirements And The Silver Spot Price
I believe speculators can contribute to a very rapid rise in silver prices since the cash requirement for owning a silver future is a small percentage of the contract’s value.
When a speculator buys silver futures on credit, they are required to have a minimum amount of cash on deposit in their margin account (also called a performance bond).
For example, suppose a speculator agrees to a long position in a silver futures contract. Price and margin requirements are ...
1NOTE: It’s assumed each silver futures contract specifies 5,000 ounces
of silver (a COMEX requirement).
The initial and maintenance margins as percentages are 12% and 9% respectively. So the speculator in this example can control a disproportionate amount of silver with a relatively small amount of cash.
Investing environments that are highly leveraged (high debt) and available to the masses can cause prices to increase sharply … especially if the supply is very limited, like silver.
A 10% margin was required to buy equities prior to the stock market crash of 1929, which began the great depression.
The real estate disaster during the last decade is another example of highly-available credit with little cash up front -- or the assurance that buyers have the sufficient financial means to sustain ownership and protect home values.
What makes silver different as a viable long-term investment? Silver's rarity is an intrinsic value that highly devalued currencies - competing for the public’s confidence - cannot match as a store of wealth.
In essence, lax credit standards lead to an increase in the money supply available for silver futures purchases. An abundance of money injected into commodity metals markets can artificially inflate the silver spot price.
Adjust Margins When Needed ... A Good or Bad Idea?
Commodity exchanges will increase margin requirements as a result
(or anticipation) of price volatility.
Metals exchanges believe the additional financial resources provided by the margin increases are needed to accommodate dynamic (volatile) price swings -- not to control prices.
When the threat of price volatility has passed, exchanges then lower the required margin amounts.
However, margin increases can cause a cooling effect on silver prices. And a change back to smaller margins can reignite silver prices.
Still, I am persuaded that gold and silver will remain viable long-term stores of wealth ... at least until sound currencies emerge as worthy alternatives.
My view is there should be a permanent increase in margin requirements. By making this change, perhaps the consequences of artificially-inflated silver prices and subsequent margin increases/decreases can be minimized.
To sum it up, reforming margin requirements for silver futures traders would likely result in less silver spot price volatility.1
1NOTE: Decreasing the maximum number of open short positions held by
any single party might also help produce a more stable silver spot
price. Another option -- require that a certain percentage of short
positions held by one party must result in delivery of physical
silver. See Price Suppression Section above for background info.
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