In Part I of this article, we looked at arbitrage between the physical metal market and the futures market. We saw that there are arbitrageurs who straddle the spread between these markets, who don’t care about price but about the difference between two prices. They seek to profit, not from a change to the gold price, but from the positive gold basis.
The basis is Future (bid) – Spot (ask)
If the basis is positive, they can buy metal and simultaneously sell it forward in the futures market (called “carrying“ the metal), and pocket about 0.6% annualized. This is far more than they could make in the Treasury market. In putting on this trade, they compress the spread because they are pushing up the spot price and pushing down the futures price.
This fact is what helps us understand what’s going on in the market. If we see a combination of (1) rising open interest (the number of futures contracts that are active), (2) a rising price, and (3) a rising basis, we know that the price is being driven by speculators bringing fresh money to the futures markets. How do we know this? Rising price means someone is buying. Rising basis means futures are going up faster than spot. Rising open interest means that new contracts are being issued (if this is unclear send us a question or comment using the form on the right side of the page and we will publish additional discussion of this point.)
Speculators in futures can bid up prices considerably. Because they are typically using leverage, they must eventually liquidate to take profits, or they can be forced to liquidate if the price falls due to stop orders and margin calls. Speculators can therefore cause great swings in the price above and below where the underlying buyers of the metal value it.
Everyone understands that the contract buyer wants the price to rise. They commonly assume that the seller of the contract wants the opposite. There is a certain appeal to this. A futures contract is zero-sum. Every dollar the price moves in either direction results in money transferred from one party to the other. There is a lot of discussion (and controversy) about this. Although there are speculators who short gold and silver hoping to profit from drops in the price (especially at certain times), I think it’s clear that most sellers of futures are arbitrageurs.
Our goal is to understand to make profitable trades by understanding the data. In brief, a falling basis indicates rising scarcity and a rising basis indicates declining scarcity. This one fact enables us to cut through the rumors that swirl around the Internet and focus on the reality in the market. Below are two graphs. One shows the basis for gold and silver (December contract). The other shows the total open interest for both gold and silver.
Gold and Silver Basis (December 2013 Contract)
Aggregate Open Interest for Gold and Silver
Together, they paint a picture of lots of speculative buying in silver and little speculative buying in gold. We don’t know precisely when—this is not a timing system—but we can say with high probability that silver will correct. Right now, an ounce of gold will buy about 52.5 ounces of silver. We predict that this ratio will rise to 60 or perhaps closer to 70.
Our firm only invests in physical gold and silver. At the present time, we are long physical gold with no exposure to silver. However, If we were trading for dollar gains using futures or ETF’s, we would do a direct arbitrage: long gold futures / short silver futures. In the stock market, we would go long GLD / short SLV.
Whenever we’re bearish, we always advise NEVER NAKED SHORT A MONETARY METAL. Postscript to this article.