"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat

Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput

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Friday, February 25, 2011

Backwardation Structure appears to Easing in Silver - but is it?

Reposting from earlier this AM:

The strong backwardation structure that has existed in the silver market for some time, at least on the futures board,  appears to be easing even as the March contract goes into its delivery period. This is happening even as we continue getting reliable reports of tightness in the spot market and long waiting periods for silver bars.

March silver's open interest is drawing down rapidly having dropped a bit over 14,000 contracts in yesterday's wild session. There is a decent amount of rolling out of March into May based on the exchange's today, but it is not a one for one roll. Both longs and shorts bailed out yesterday.

There are still a considerable number of contracts open in March, 14,259 to be exact, but we have today's session yet which no doubt will see a further reduction in that contract month.

If a squeeze is going to occur, we will need to see the March return to a premium to the May and preferably also to the July.

Here are the spread charts detailing the change from one of backwardation to a more normal contango situation. When a backwardation structure exists, the spread line will be above zero; when contango exists, the spread will be below zero.

As you can see, the backwardation structure has been easing. At the risk of repeating, if there will be a move to push the shorts during the delivery period in the March next week, this spread line will indicate it by moving back above zero against the May and if it is particularly strong, also against the July contract. I do wish to point out however that while the backwardation structure of the March has eased it is just barely in contango.

Keep in mind that this chart is a snapshot in time and can change so we will need to continue to monitor this for further developments.

To get an even more accurate read on this we would need to capture a snapshot in time comparing the spot silver market bid/offer to the current bid/offer of the nearby March silver contract. At the time I am posting this, spot silver is actually trading about 6 - 7 cents higher than the nearby March futures contract which makes the current structure of the Comex silver market seemingly at odds with the physical market once again. In other words, we have a rather strong backwardation in the physical market but an easing backwardation moving towards contango on the paper market.

An ideal situation for a short squeeze exists when both the futures board and the spot market are speaking with the same voice. In the case of what we have now, if the physical market is as tight as it seems to be, there should be a large number of players standing for delivery in the March. AFter all, if you are a large buyer of silver, and you can get the exact thing by buying a March futures contract at what is a DISCOUNT to the physical market, who in their right mind would not want to do that? If nothing else, a player with the right connections could arbitrage the setup and guarantee an immediate and healthy profit.

Stay tuned on this one. With Silver there is never a dull moment.


  1. Flaunt;

    The point in keying in on the March contract is because that is the one that will govern the delivery process in silver when it enters its delivery period next week. If the tightness that curently exists in the silver market continues and the spot market or cash price of silver remains at a premium to the March Contract, I would expect to see large stoppers taking delivery which would put severe pressure on the shorts who would of course have to come up with the metal. Where are they going to get it based on the reports of tightness of available supply. That is why the next couple of weeks should be very interesting to say the least to see how all of this shakes out.

  2. Great post Dan. You make a great point regarding the premium that spot price is to futures, but where are you getting your spot price. There is no central physical gold exchange with minute-by-minute spot transactions. Spot is really based on futures and what each particular dealer is quoting isn't it. If so, the arb opportunity might be fleeting.

    Great blog!

  3. Brian;

    You are right about the spot market but one thing I have noticed over the years is that rarely does a situation exist where you have a spot market transaction that consistently trades at a premium to a nearby futures contract throughout the day unless there is a good reason for it to be so doing.

    It will generally not last long unless there is a strong reason for it to last because arbitragers can move very quickly to take advantage of such things if they have good contacts in the physical markets.
    I used to watch guys play the pork belly contract by taking delivery of the bellies and then selling them on the cash market and making a nice profit. They of course had a good system to do that as it obviously involves some gymnastics but it can be done. With bellies you had a frozen commodity that needed refrigeration and was perishable. With silver that does not exist as a problem.

    there are simply not a lot of guys who are set up to do something like this but it is done.

    An example - suppose I was able to buy one million ounces of silver on the March contract at the Comex at a 6 cent discount to the spot market while I was able to nearly simultaneously sell that same one million ounces on the spot market with the idea to deliver the metal at a specified date. I make a gross profit of $60,000. After taking out expenses for delivery fees, shipping, etc., I would still walk away with a tidy sum. Not bad for a day's work.

  4. Dan: indeed, seeing spot higher than futures is a remarkable anomaly and as you pointed out, really shouldn't occur as arbs should be ready to exploit it until it closes. And like you said, because this is such a rare occurrence, there aren't a lot of guys set up to do this.

    But I'd submit that perhaps spot really isn't what is being quoted for such size transactions. That is, once you hit the market with 1 million oz of physical to sell, the spot price drops 6 cents and you're even. Though I'd admit that I don't know enough about how size physical transactions are priced and executed. I'd assume that a dealer wouldn't be willing to take the other side of the trade (buy your physical) unless he could hedge - and that would have to be in the futures market. Unless, of course, he is short and really needs it!

    Sorry to ramble, but this is very interesting and I appreciate you pointing it all out.


  5. Hi Dan,

    Can't emphasize enough how great your blog is. Has become a daily read for a lot of us now. I'm new to the futures market and am wondering do you have older posts regarding getting started in futures, or any books/blogs that you recommend for beginners.


  6. TD - I have the same interest as Butch. Also, a quick definition with examples of contango v. backwardation would be useful.

  7. Robert Leroy Parker - Butch - pick up a book on technical analysis by Edwards and Magee which is a good primer. Also Steve Nison is good on CAndlesticks.
    Those will help you learn the concepts from which you can then build upon.

  8. Streinikov

    Contango exists when the futures market has a price structure when the nearby contract is cheaper than the more distant contracts as you move out the board.

    Backwardation exists when the opposite is true - the nearby futures contract is trading at a premiumm to the next month and the months after that. It signifies very strong demand and eager buyers who are willing to pay up to obtain the commodity immediately rather than waiting.

    These are very general relations however since the grains and the livestock markets will have different board structures based on the crop year and the breeding cycles. For the most part the above definitions are reliable.

    Markets in backwardation are not all that common so when you do see it occur, it tells you that supply is insufficient for the current level of demand


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