"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


Sunday, February 20, 2011

What is a Commercial Signal Failure

This is in response to a special request from my pal the Turd who has asked me if I would take a bit of time to explain the titled term. It dovetails nicely with my comments on the impact of margin requirement hikes by the exchanges.

Let me begin this explanation by saying that these events are relatively rare. Over the course of my career I can probably count the number of times that I have seen them occur on both hands. That is not to say that there have not been more, but in the particular markets that I actively trade, they are infrequent. However, when they do occur, the resultant price moves are spectacular; i.e. if you happen to be on the correct side. If you are not - well - you are probably no longer reading posts or having anything else to do with commodity futures markets and are gainfully employed elsewhere having had your net worth reduced by multiples.

Let's also take a Commercial Signal Failure (hereafter referred to as CSF) in a bull market. I have seen one occur in the hog market twice in my career and those were strong bear moves that resulted from chicken import bans and H1N1 outbreaks but for the most part, these things happen in a bull market.

Here is the scenario - a market begins a trending move higher. Speculators are on the long side driving the price upward with the Commercials (producers, processors, etc.) instituting hedges for risk management and selling into the speculator buying. This is all healthy and normal for the Commercials are using the futures markets for the reason that they came into being - they are locking in profit margins and eliminating price risk by transferring that risk to a speculator who is willing to assume the risk in the hopes of making money as prices move higher. It is also the reason that all bull markets that have any lasting power will always see a rise in open interest as price moves higher. Commercials are employing scale up selling programs to lock in successively higher sales prices for their production. This can be abused as it has been in gold and silver but that is another story that we all know too well.

As the price continues to move higher, commercials will attempt to take advantage of the speculative buying and will sell more and more of their expected future production. In other words, the size of their short position continues to grow as they cover their risk management needs. Now in order to maintain this short position, they are required like anyone else who has a position in the futures market to post margin. Bona fide hedgers have a distinct advantage in this however since the margin requirements for a hedger are less than that required by a speculator to post. In other words, they can control more contracts for the same amount of money than can a speculator.

The reason for this is because supposedly there is less risk for a hedger from a financial standpoint because they actually produce the commodity that they are hedging. If they lose money on the hedge, the short position, that is offset by the corresponding rise in the physical commodity. This conceivably puts them on a sounder financial footing than a speculator who is putting risk money up without having access to the underlying physical.

So far the scenario is developing like it does in every single bull market - the price rises, the speculators are on the long side, the commercials are on the short side, and the total open interest (number of contracts open) is rising. Obviously the speculators are now showing good open or paper profits on their long positions with the commercials showing paper losses on their open short positions. As price continues to rise, these commercials will also be required to post additional margin money to bring their positions back to what is called the maintenance level. The higher the price rises, the more money they must expend to meet all the clearinghouse requirements. That however is generally not a problem since these things are accounted for in their risk management programs and they have access to lines of credit which will allow them to make good on these financial requirements.

A problem develops for them however when there is an event, an occurence or development of some sort which drastically changes the supply/demand picture overnight. For example, a hard freeze could crush the Florida orange crop; a severe drought or flood could wipe out a substantial portion of a major agricultural crop, a livestock disease could surface in a major producing nation, a blight could strike the cocoa producing areas of West Africa, it could nearly anything. Whatever the event, it triggers an immediate shift in that fundamental supply and demand equation that results in a huge imbalance between demand and supply in favor of the speculators. In other words, supply has been severely impacted and sharply reduced or demand has shot up suddenly and is now grossly overwhelming supply. The result - prices spike rapidly upward and begin to accelerate higher as the market must now come to terms with the new and greatly alterated supply/demand equilibrium.

Commercials, who now find themselves on the short side of the market with a substantial position are suddenly caught flatfooted as panic buying grips the market and all offers to sell instantly disappear. The result is a massive air pocket above the market with a huge imbalance of buyers and sellers. Simply put - there are no sellers, anywhere. Everyone wants to buy and they have no one to buy from. What happens? Price must rise higher and higher until it reaches a level where the sellers, those who actually have the product, feel comfortable letting some of their supply go.

Some might say, well, what is the big deal for those commercials? After all, they have the product and while they are losing money on their short hedges, they are making it back on the physical side of thing because they actually produce the commodity. That is true and in a normal bull market, that is exactly what happens, but in a situation as above, where the event has come out of nowhere and was not anticipated and is of such magnitude that it severely throws the balance between supply/demand grossly out of balance, even these commercials are impacted.

Why is this? The answer goes back to the margin requirements. In a rising market, commercial hedgers with short positions are constantly losing money on those hedges and are required to post additional sums of money to keep current and maintain those short positions. As stated previously, to do this they draw from their own reserves which are set aside for risk management purposes. In addition they have lines of credit from various lenders who loan them the money for such purposes. But when an event alters the market dynamics to such an extent that price begins to gap higher and accelerates upward, their lines of credit are no longer sufficient to cover the paper losses on their open short positions.

In other words, they run into the exact same position as a speculator who has a market moving against him and no longer has the financial resources to maintain his margin deposit at the proper level. They are forced to get out of their positions because they have run out of money to maintain them. Unable to get any further credit and having drawn down their own reserves, they are now defenseless and must buy back the existing shorts to prevent the financial ruin of their firm.

They too now enter the buying frenzy only this time, their ability to get out of their shorts determines whether or not their firm will survive. They will hit every single available offer to sell that might appear because their very life depends on getting out. They do not care what the cost is - they must get out.

The implications are obvious - price will rise and rise and rise until every last one of those losing short positions have been cleaned out to the level that enables that firm to survive. As to how high that market will then go, it is anyone's guess. Quite frankly no one knows. It will stop at some point but by then the damage to the shorts is staggering.

Over the years I have seen entire firms go down when an event such as this transpired.

Here are a few charts detailing the results of a CSF. The first is in Live Cattle and the second is in Minneapolis Wheat.

With Live Cattle, the "black swan" event was the discovery of a cow in Canada back in 2003 that came down with "mad cow" disease resulting in the US authorities closing the border to all shipments of Canadian beef and live cattle. The result was an immediate shift in the supply/demand balance with US supply sharply curtailed and unable to meet the then existing demand. Price shot sharply higher moving limit up 8 days in a row, 5 of those days being gaps in which the market basically shut down because there was no one to sell.

I can still remember the cries and pleas from the commercials who were members of the CME for the exchange to do something because they could not get out and were being ruined.

The Minneapolis Wheat market, back in the winter of 2008, was roiled by a perfect storm of developments that seemed to come together all at once. Horrific crop weather, soaring demand, export bans from wheat growing countries, it just all hit at once. The result was the most spectacular Commercial Signal Failure that I have ever seen. Price soared from an already expensive $10.00/bushel to nearly $24.50 for a single bushel of this wheat! The market literally did not trade for days on end as it opened at limit bid day after day with absolutely no one to sell. There were more than a few firms who were destroyed as a result of their short hedges in this market.

I do want to point out something about these CSF's. Note that once they run their course, the market generally collapses and gives back a very large percentage of its overall gains. That is because once all the Commercials have finished buying back their bleeding short positions, there is no one left to buy and prices now come tumbling back to earth. In some cases, all the price rise is erased; in other cases a substantial portion are given back but the market then finds a footing at a new and higher price level.

As with any market, the potential always exists for such a development especially when there exists a very large short contingent in a market that has already seen a decent price rise. Any further exacerbations of the supply/demand balance can trigger one of these events.  If one does happen in silver, trust me on this one, you will not have to ask the question: "Gee I wonder if we are seeing a Commercial Signal Failure in Silver". You will know it.


  1. geez Dan, great post. Quite informative and much appreciated.

  2. Gettin' it done Trader Dan! Thanks for the note. Looking forward to seeing the casualties on the battlefield next week, and hoping I'm not one of 'em. See you there!

  3. Great lesson from the past and the mechanics of why and how these things work. This gives me the knowledge I need should a CSF happen with silver. I always wondered what I'd do if there were a parabolic rise. Now I know.

    Dan, thanks for taking the considerable time to educated us.

  4. Dan...noob question but is there a limit up/down in Ag/Au or any of the other PM's? I have seen absolutely no indication of this so would assume the answer is no.

  5. Thanks for the explanation Dan. What kinds of scenarios might cause a supply shock overnight in the precious metals? A panic out of USD? Has one ever happened before in gold or silver?

    I see there was talk about a possible CSF in March of 2008. There were about 10 up days at the end of February but it doesn't look like as powerful a move as these other charts you were showing.

  6. I'm guessing that if we had another big bank collapse we could see something like this? Or if China announces a huge plan for buying.

    Great article.

  7. Outstanding post Dan,

    Can't thank you enough for spreading you're knowledge to the blogger community.

    If silver starts gapping up each day this week, I believe just about every person reading this is going to make a substantial sum of money.

  8. Dan,

    I have a very big favor to ask on the behalf of deaf researchers interested in your work. I am deaf, so I'm not able to follow the KWN audio/video interviews. We would very much appreciate written transcripts of the interviews be made and links to them supplied to all the contacts that receive notifications of the interviews (I get them through GATA, for example).

    Thank you for any way you can help.

  9. Dan: I can't describe how fantastic this post is. Thank you very much!

  10. Dan,

    Further to 6a1dbc....above, we have a lousy internet connection...slow as and expensive. Streaming audio is almost not worth it so I always look for transcripts too.

    Thank you for a wonderful service.

  11. Trader Dan,

    Just a great post. Turd has been asking, actually almost demanding, readers of his blog to check out yours. As usual, I am glad I follow the Turd's advice.

    I asked this question on Friday but I think it got lost at the end of a thread, so bear with me if I repeat it, and elaborate a little.

    What probability do you assign to a DISorderly rise to silver prices this week??

    For instance, what probability to $35? to $40?? to $50???

    fwiw, Turd gave it a 40% chance of $35. IF it hits $35, he estimated a 10% chance of $40 and a 2% chance of $50.

    Any chance we can get your insight here? :-)

  12. 6a1 and Nic - thank you for your interest in a written transcript however Eric King does not as of yet make those available. I wish I could accomodate your requests but unfortunately am unable to.

  13. Cris - my own personal style as a trader is to not attempt to put odds on a move because I then end up getting too biased by my own opinion and cannot be objective as I need to be. I am not against folks doing it; I just am not very good at it.

    I prefer instead to just watch the price action and see how the market handles resistance levels. Silver this week has taken them out as if they were non-existent. That tells me that some large short is in serious trouble and that buying momentum is extremely strong. If silver can take out the region near $33.25 - $33.50 I am expecting it to then make a sharp push towards $35. If it takes out $35, my goodness, this thing is going to get ugly for the shorts!

  14. Great information here, and very well written - thanks !

  15. Thisisrich - there are no trading limits on the gold and silver futures markets - at least not at this point.

  16. Dan,
    another fantastic post. Thank you.
    Harvey Organ and other have just noted the spiking lease rates for silver. What does this mean for participants in the spot XAG and XAU markets?

  17. 6a1 & Nic

    Looks like your next step is to contact KWN directly, since they own that material, and ask them about transcripts. I see a "Contact Us" link way at the bottom of their page.

  18. Simply a great post Dan... many thanks to you (and to "The Turd" for the link)!

  19. Astoundingly informative post Dan. Thanks for your commentary on KWN every week; that's my favorite audio spot of the week for sure!

  20. Thanks Dan. I learned a lot. Fascinating stuff!!

  21. Trader Dan, one day I’ll just ask a simple question, make a point or briefly opine on your blog without praising you… but not today, on any of the above. For one, you keep knocking it out of the park with your thoughtful, timely and instructional voice of reason.

    To underline one of your points about ‘bleacher’ analysts that don’t dare step on the playing field, I’ll resort to another metaphor with the old adage: those who know, do, and those who don’t, well, you know. On rare occasions we find one who does know, and do… and teach. Thanks for being all three.

    Ok, enough with the baseball analogies and props. Now, on to precious metals and commodity investing: will we see a parabolic rise in silver this week?

    Are charts the only safe window looking outside of a circus playhouse full of tilting floors, scary goblins popping out of the shadows and warped mirrors?

    To state the painfully obvious, today we’re witnessing multiple worldwide events that will continue to significantly alter the world and our way of life. The scale and scope of change may wind up being more significant than in recorded history. On the edge of what is and will continue to be turmoil and a financial abyss for many, we see the very real possibility of economic ruin for nations, institutions, communities and individuals.

    At the same time and due to the same circumstances we see a unique, once in a lifetime opportunity to not only to survive, but profit greatly in this global upheaval and transition.

    To varying degrees, we all follow the news, we watch the markets, we are attentive to the fundamentals of our investments and we see the charts. We’ve read of the rise and fall of civilizations and sovereign currency throughout history. Without delving further into the historic macro, micro-ness of it all, I’ll ask a few questions that may initially seem rhetorical:

    How do we avoid being shackled or trounced by the manipulative forces at work? More specifically, how do we play this historic move in precious metals and commodities right, for the sake of our families and those we wish to help?

    How do we invest against and through the psyops and disinformation thrown out like cheap beads at Mardi Gras? How do we place reasonable stops when the android algorithms are unleashed to launch a snatch and grab (and flash) attacks? So many questions...

    (due to google-enforced limitations (just informed… what?), I split my post in two parts)

  22. Part deux:

    We know that market fundamentals are critically important to consider (silver backwardation, QE, war, etc). Yet, when the crooks, the self-serving spin-meisters, the thieves and dubious market-makers manipulate, the fundamentals as well as the raptors, aggressive commercials and banksters behave as they would in a bizarre world where north is south, good is bad and everything is the opposite of what it should be.

    Their cohorts and useful parrots in the media that provide the resulting “noise” are (usually) easy to ignore like flies at a picnic, but when you have Botox Bennie and Geitner’s Guiseness in play like a tragic theatre of the absurd, getting the truth in a world of lies and half-truths is like picking gnat poop out of pepper. On top of all that, we have the Black Swan scenarios and commercial signal failures to contend with. Lions and tigers and bears, oh, my…

    But in all seriousness, getting it right in the coming days, weeks and months is going to take some doing, particularly when we are playing on a not-so-level field in Bizarro World. The rules will change without warning, logic, reason, fundamentals or even rule of law. We (here on blogs such as this) will increasingly depend on those that create and interpret the charts and teach those of us that are not expert traders or savvy investors.

    As important as fundamentals are… they can’t always be counted upon because they lie. This is due to, well, liars. Charts are not affected by lies nearly as much and will provide clarity through noise. To be fair, charts fib now and then too (pun unintended and with all due respect to the famous Italian), but the skillful interpretation of charts will continue to be more honest and accurate than the (reported) fundamentals that are subject to all manner of misinterpretation and misdeed.

    While we may not need a weatherman to tell us which way the wind does blow, but it sure is a comfort to have access to honest experts that tell us what the Doppler radar shows.

    Thanks again Dan. Looks like red sky in the morning?

  23. Being a non-financial type (mere engineer), I still struggle to understand even this obviously very clear explanation. I did get *some* of it, so thanks for trying to educate the market-challenged Dan!

    One question I have- what happens after a CSF, if the supply/demand fundamentals are _still_ well into permanent shortage territory? Silver stocks now less than gold, supply inelastic and substantially less than still-rising demand, moves to monetize silver but with insufficient physical available, defaults at COMEX, etc.

    Would that make the usual fallback after a CSF unlikely?

  24. Wow! As a futures trader, I've never seen such a great explanation of a commercial signal failure. When you add in the fact that the commercial shorts in silver, for the most part, don't actually own any silver, the final bull manic phase has got to reach above $100 an ounce In my opinion. Of course the question is how soon, when will this happen (if ever).

  25. Larry, this is a great post. I read all this about the shorts, etc. who are in there trading, but where does it leave us small fry who simply want to hedge against the dollar/financial chaos.

    Is this information better left on "ignore" for those of us not actively trading futures???

    I'm finding it difficult to separate out what can be applied to someone like me, who is simply holding PMs in physical form...

  26. Fantastic Description Dan.

    It really made me reconsider my strategy with PM's of which I'm overweight Silver. I hold about 50% physical silver and 50% miners ie silver wheaton.

    Now I'm wondering which of the miners are hedged especially given that there appear to be forces at play beyond the norm.

    As you mentioned, the shorts that will be trying to cover should shit hit the fan will include miners that have hedged their bets.

    food for thought.

  27. Trader Dan, thanks for the good work, I am learning a boatload..

  28. Just so we're clear -- mining companies that are hedged could get wiped out in a CSF?

    That makes me want to reconsider some of my miners and do some more investigating into which ones are hedged.

  29. Does the federal reserve fund the margin for jpmorgan and other big shorts in the silver market? I have observed in the past that when a particular commodity's limit is expanded, it usually ends in a top or bottome shortly thereafter.

  30. Never heard of a CSF before tonight, but its a great perspective when you think of precious metals as a commodity. When you think of PMs as a true currency, I can't imagine a CSF in gold and silver.

    I just don't see it happening, because these metals are still viewed by so many as backdrops to currency.

  31. My thanks for offering us this timely and in-depth analysis of what may be just around the corner. It gives me new hope that each individual buyer of silver may in fact contribute to the toppling of JPM. Blood is in the water, and the sharks have been released from the pens.

  32. Stock and Blorf;

    Mining companies have legitimate hedging needs but run the real risk of getting hurt if they misjudge the market and overhedge. Look at what happened to Barrick's profits back in the last decade when they were forced to unwind their hedge book at much higher prices than when the hedges were instituted.

    Some of these firms need to employ some better chart readers to get a feel for the price action of a market before they get too carried away on the hedging and overdo it.

    Also remember that a lot of mining companies were forced by the bullion banks who lent them money to institute hedges as part of the loan terms.

  33. Hey Trader Dan,

    That's a fantastic post. Thank you!

  34. Larry - thanks for the post - when a market moves into a fresh 30 year high territory, it might as well be in uncharted territory from a TA perspective as we are all extrapolating price projections now and attempting to work within those boundaries. I keep remembering back while I was doing the Minn Wheat thing back in 2008 when the heck was this thing going to stop going up. Each day it just seemed as if we were never going to see another bushel of wheat ever produced again. Of course in truth we all knew that could not happen but when one of these CSF's actually do occur, trying to pinpoint a level at which the price will stop going up is basically an exercise in futility. We just have to wait and see when the market exhausts itself to the upside.

  35. Explorers are less likely to be hedgers :)

    Buyers will likely overvalue them during a price spike.

  36. Regarding the hedged silver producers, this applies mainly to base metal companies with silver as a byproduct (these companies are the biggest producers of silver). Primary silver/PM producers are unhedged, by and large.

    That also means companies included in the ETFs like GDXJ and SIL should be in good shape overall. I don't think there's any reason to fear that ETFs like this will underperform because of massive hedging by the companies that make up the funds.

  37. I think of your description of firms buying just to stave alive as someone trapped under water.

    They need a breath, right now, and will pay anything.

    Thank you!

  38. Thanks Dan, very educational. Keep it up! :)

  39. Add another voice to the newcomers and converts! You have explained this all very well indeed. Bravo!

  40. Thanks Dan .... feel like my peripheral vision just widened considerably!

  41. Like many others here I am invested in silver ... actually 90% physical silver, 10% physical Gold.
    This has been my position for the last 3 years ... 3 1/2 years ago physical silver an gold was my core position an made up roughly 15% of my portfolio, I lost the other 85%.
    So it pays it pays to have a core postion that u dont touch no matter how badly things go wrong with your portfolio / trading account as your confidence shrinks its a battle to hang on.
    A speculator at least 1 point in this career goes bust or close to it :)... well maybe more than once :)
    So Ive been lucky the core postion has doubled ($AUS) an I can think about spreading the wings a bit ... maybe another read first of "Reminiscences of a stock operator" and posts like this one from Trader Dan.
    The moral of the story is that at times in the past I have become emotionally attached to investemts this an effects your decisons ... an physical silver is not hard to be emotionally attached to ... its beautiful stuff. Hope everyone has a good ride on silver an dont get emotionally attached to it.
    Looks like I've been given another chance:) ... many thanks Trader Dan u have started off your blog with very readable commonsence an pratical posts ... long may it continue.

  42. @Robert Bonomo,

    be careful with your boatload. I lost my PM's in an unfortunate boating accident. And then again 3 months later. I've heard reports of similar occurrences. Something strange is happening on our waterways.

  43. Trader Dan, since you’re still standing and have such a good perspective on the cattle and wheat commercial signal failures, I’m guessing that you either did well or stepped aside. Amazing charts. No doubt some shorts and unfortunate opportunistic bulls that arrived late to the events became mad cows and chaff themselves.

    Seeing those and looking at the volcanic gold charts of the 1979 eruption then 1980 collapse is as frightening as it is exciting.

    Note to self: remember parachute if fortunate enough to ride a rocket.

  44. Amazing article. Thank you Dan.

  45. Excellent Post. Thanks Dan. If you could occasionally provide educational pieces like this, it would be greatly appreciated.

    Love the new website. I'm sure jsmineset misses you.

  46. thank you very very much for this wonderful gift of knowledge

  47. Hi Dan,

    I'm a huge fan of your work, great post!  Hoping you or anyone else can help clarify something for me.  I can completely understand how a short who is not in possession of the underlying (a naked short) would be fighting for his/her life if the price got away from him/her to the upside.  Especially on the front month delivery contract with time running out to close before the price escalates even further or alternatively being forced into the cash market to buy the physical for delivery (which is essentially the same thing but even more of a pain.). 

    So that part I completely understand, but unless I'm missing something the way your post reads it seams to suggest that the producers (commercial hedgers), those with legit hedging needs as opposed to the speculators, are the ones getting squized - to the point were they could potentially face bankruptcy.  But if  they are in possession of the underlying from the start where is the financial risk -  isn't that why its called hedging to begin with?  Is this not similar to a covered call option?  Sure there is the opportunity cost of not selling the underlying at the higher future price (spot price at delivery) but wouldn't the commercial hedger have locked in a profit the day he/she put on the initial short (the sale)?

    Is it the daily mark to market settlement via increased margin deposits that are squeezing them?  If so, such as in the case of silver, could said commercial deposit the entire contract underlying (bullion) in a Comex warehouse and say 'see I have the delivery in full stop asking me to increase my margin?'  I know there is serious doubt as to the commercials actual possession of bullion in the current context but I'm speaking hypothetically and in general terms.


  48. VictorE - keep in mind that those who hedge are more often than not hedging FUTURE expected production. That means that they fully expect to have the underlying commodity at some point down the road and are locking in a profit on that product that they hope to realize when they actually do produce the commodity and then lift the hedge. The problem is one of cash flow. While they have instituted the hedge, based on what I might add is their assessment of the supply/demand picture at the time, they begin to lose money on the short position as the market moves higher and they often times do not have the financial wherewithal to meet the increased margin calls to offset the paper losses. The result can be horrific if the market gets sharply away from them because the must make good the margin requirements OVERNIGHT or in some cases, the very same day. If they cannot, they are forced to get out.

  49. Hi Dan, thanks for clarifying! So if I understand you correctly it's not really the front month that's doing the squeezing (since in theory a legit hedger would actually have that underlying on hand) but rather the further out months (which could number many years out) for which the commercial/producer does not yet have the underlying, that forces him/her into a cash-flow squeze via margin increases.



  50. Here is the question we should be asking : how can you tell the top of a commercial failure event (in real time)? the plan would be to get out of Silver into something else at that point, before the big pullback...

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  53. This blog post is highly informational and matured enough with its quality and layout in defining audio transcription in Canada. I will wait for more such informative posts in future.

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