"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


Saturday, April 16, 2011

Hedge Fund Ratio Spread Trades Continue to Distort the Value of the Mining Shares

I hope to have further on this topic sometime this weekend depending on time constraints but I wanted to at least get some charts up to demonstrate how severely undervalued many of the mining shares are in relation to the underlying metal as a result of the plying of this particular trading strategy.

One of the factors that I believe are involved with this severe underperformance of the shares in general is the advent of the ETF's. Those who want LEVERAGED EXPOSURE to either or both gold and silver can now use the ETF's to do so.

Formerly, there were two methods available - commodity futures or mining shares. Since the charters of some funds prevents them from investing or trading in commodity futures, funds who wanted this leveraged exposure to the metals were forced to go into the mining shares in the past. That implied that bull markets in the metals were going to see substantial money flows coming into the shares.

Since the ETF's came along, those institutions looking for leveraged exposure to gold can now directly purchase the silver or gold ETF's instead and margin those up to obtain leverage. In other words, they are no longer captive to using only the mining shares.

Additionally, the hedge funds, which have proliferated like mushrooms after a summer rain, are able to offer prospective clients exposure to the commodity markets since there is nothing in their charters preventing them from investing in the commodity markets. That attracts further funds that in time past would have flowed into the mining sector directly.

Keep in mind what is necessary to drive prices higher - sustained investment flows. Now, if the investment flows that formerly would be diverted directly to the mining shares have been split and are now moving directly into the commodity futures markets and the ETF's, that pulls a portion away from the shares. That means that there is a bit of an exploitable weakness, a chink in the armor if you will,  in the sense that the amount of firepower coming into the shares, is weaker when compared to the other alternative forums for investing in the precious metals.

The hedge funds understanding this then employ a strategy designed to take advantage of the "weaker sister" which suffers somewhat from the smaller money flows heading its direction - they short some of the mining shares while buying the commodity futures and the ETF's. That selling then further absorbs the buying interest that is still heading into the mining sector shares.

The reason they do this is because it helps them manage their risk. When the market sells off in this volatile environment, they are able to profit from the short leg of this trade as the shares head lower generally at a faster rate than the metals themselves do. In other words, they might be losing $1.00 on their long gold or silver positions in the futures or ETF's, but making $1.10 - $1.20 on their short share position. In effect, they have a permanent put option.

This trade has been extremely effective for them which is why they seemingly refuse to give it up but at some point, the effect is to so distort the price of the mining shares in relation to the underlying metal, that something has to snap to bring the share price back in line to historical norms. After all, the higher the metals run in price, the more profitable the well run miners become. Stock prices are eventually determined by profits - Eventually some of the hedge funds plying this trade will begin to realize that they are pushing the trade too far and will begin to exit. That will set off a rush by the others to do the same.

We got a brief taste of this April 5 of this year when the HUI shot up nearly 30 points in a single day. That was the first sign that the days of this trade are drawing to a close. There is an old adage in the trading world which is apropos for this situation:

Bulls make money; Bears make money; but Pigs get slaughtered.

Hedgies beware. The time is coming when there are not going to be any sellers on the other side of your trade when you need to unwind it.


  1. crystal clear and informative - as always; thx Dan

  2. Thanks for addressing the comatose metals stocks Trader Dan. Gold and silver are going nuts, but the PM equities are losing value. If Hedgies are to blame and their scam will soon be up, that day can't arrive soon enough for me. Meanwhile, the bulls and bears are making money, but PM shareholders are the ones getting slaughtered.

  3. (1) What is the source of information to indicate that hedge funds are short miners?

    (2) I've been looking at the spring 2006 bull run in gold, silver and mining shares. If we are following that model this year, then next week could literally be the breakout week in the miners. We're about a week behind the 2006 pace, but after the last short-term correction, the mining shares began to take off in the second week of April 2006. So perhaps we shall soon see if 2006 is any guide to the current action.

  4. Great article, Dan. I've bookmarked it, and I'll be sending other folks here for reassurance.

  5. Thanks Dan for your insights into mining shares woes. In lieu of yesterday's in your face negative action in many mining shares there could be more to this story than hedge funds ratio trade. I have observed that in the past just prior to a take down in the PM metals arena mining shares are sold down as the insiders to the game are given advance notice of the plans. It can also be viewed as a momentum stopper for those new to precious metals who are considering investing in mining shares as a KEEP AWAY! tactic. Those opposed to PM will use all means at stopping joe q public from jumping in, anyway just my feelings in what I see happening.

  6. Thanks Trader Dan, if I ever run into you on the street, I'll buy you a cool one in Chi-town

  7. Yamana is a CLASSIC example of this Dan. You're 100% correct: One day soon, this trade is going to BLOW UP on the hedgies.

    p.s. Check out silverdocs' new game for some comic relief: Punt The Bernank


  8. Thank you so much Dan for your excellent work. There are not many people in this world that offer something of real value free of any charge. Your work is always very valuable and invariably very accurate. I too would buy you a drink!

  9. Hi Dan, Thank you for everything you do for us.

    What about rising costs to mine the metal, risks associated with mining in general, and possible peak production? Could there be more going on than just a ratio spread?

  10. Laurence Hunt,

    Do you mind clarifying your second point as you state that "mining shares began to take off in the second week of April 2006" but according to my historical charts they topped out in the third week of april 2006?

  11. Thank you so much for the explanation. Where can I find charts for the HUI / silver ratio? Thanks.

  12. @Joey.


    type in $hui:$Silver in the symbol field.


  13. Dan,

    HUI had a really good second week of April in 2006, but the top (15 points higher) occurred the second week of May. (I remember it well!) The last 1/3 of January 06 was also strong for the HUI.

    If you look at SPTGD (I'm in Canada), that ran straight up from the 2nd week of March to the 2nd week of May. CDW gained 6c during the same period (weakening the SPTGD price action overall).

    Still interested in your info source on hedgies shorting miners.... Is there someplace you can get that kind of information?

  14. Thank you, Dan. Your insights are very much appreciated.

  15. Golden Star Resources GSS became a prime candidate to short when they entered into a cashless collar for their 2011 production. Check out their large short and chart showing they only participate on the downside of precious metals market moves. Hope you are correct that this will end soon.

  16. Just found this site, courtesy to Jesses Cafe. As someone also in the same boat with my miners I have to add that this link may bring a little more insight on how the HUI may be ready for a bounce north.
    Hope this is of use.


  17. i have been with tre a long time,- not been a lot of fun,but now that i know that these puts are killing us all,- i'm going to hang in there and see what happens.

  18. i still dont get how miners lowered, while the pm went higher..

    aren't the etfs in essence BUYING into these miners as well?

  19. this trade depends on no QE. QE3, by whatever name, will put an end to this trade.

  20. SLV traded 186 million shares today. About 27% of annual production of silver. Looks like the HFT Bots have a new toy.


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