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AgAuGal | 08-02-2006 03:54 AM
Explanation of Silver Basis http://www.silveraxis.com/explain_basis.html SILVERAXIS.com - Explanation of Silver Basis Basis is the spread between the spot price (cash, physical or local price) and the futures price of a commodity. Basis is important primarily in agricultural and other markets where product warehousing serves to balance supply and demand. Because the warehouse operator can deliver product to, or withhold it from, the market when there is a wide disparity between the local or current price and the exchange-traded, futures price, the basis can be said to measure the efficiency and effectiveness of the markets. Ideally, the basis represents the holding or transportation cost of a commodity allowing for a small warehouse profit. Otherwise, the arbitrage profit opportunity will be tempting to enough warehouse operators who will compete in the market until excess profits are reduced and the basis returns to near ideal levels. In actual practice, basis may temporarily shrink or grow in reaction to supply and demand in both the spot and futures markets as markets are never 100% efficient. So what do different levels of basis indicate? All things being equal, the normal condition for a commodity is to have a positive basis where the futures price is higher than the spot price. This condition is called contango, which can be viewed as the cost to carry a commodity in inventory including storage fees, insurance and interest plus cost to transport to market. The reason contango is said to be a normal condition is because arbitrageurs can usually make risk free profits when contango is significantly different from the carrying cost. They do this by trading the price spread between the spot delivery month and the future delivery month whose price is out of whack. For example, if contango is too high, an arbitrageur can buy a commodity in the spot month and immediately sell a contract in the futures market at a price higher than the spot price just paid plus the costs to store and transport. As long as the carrying cost is fixed (sometimes it isn't, and this itself can cause changes in the basis), the arbitrageur will have locked in a risk free profit. He or she can repeat this trade as long as the contango remains too high, but eventually the excess spot demand and excess futures supply will reduce contango to a normal level. The opposite of contango, backwardation, happens when the futures price is lower than the spot price. Backwardation indicates that spot demand exceeds speculative expectations for future prices and is usually associated with markets experiencing what is assumed to be temporary tightness in physical supply. For example, backwardation has been a consistent feature of energy markets for years thanks to the peculiarities of energy supply (mostly due to the manipulative acts of OPEC and other command economy oil exporters as well as the difficulty of above ground storage of oil and gas). On the other hand, gold and silver rarely ever experience backwardation. That is, until recently, when silver started showing reduced contango and even moderate backwardation. It is too early to tell if this condition represents a temporary spike in speculative demand in the spot market resulting from unusually large money flows (something I have pointed out for months now using lease rates). Certainly the silver ETF and its front runners are expected to have a lot to do with this spot demand for physical metal. Remember that backwardation can occur simply due to tight supplies and incessant demand (whether fundamental or speculative in nature) in the spot market. In fact, we can see plenty of speculative behavior in silver lease rates, where the spot market is being bought and metal is then being leased for various lengths of time to help offset carrying costs. Meanwhile, what may be happening in the futures markets is that speculators are net sellers of futures contracts against their physical silver holdings, which, combined with weak demand for futures in general at higher prices is probably keeping a lid on futures prices and creating backwardation. Basis risk is the risk that prices in the futures market will not follow the spot market up or down for a variety of reasons but usually due to widespread fear of an imminent default, closure or major rule change of the futures exchange. Basis risk is not very relevant for most small speculators who hold simple positions which are not hedged or offset, but it is a key consideration for many sophisticated market players as explained by Antal Fekete in the thought-provoking Bull in Bear's Skin? and Ultracrepidarian Musings. Mr. Fekete makes a very good point that basis risk is bound or limited on the upside (basis will never substantially exceed the carrying cost of a commodity; see below for why) but is unbound and unlimited on the downside (where risk is theoretically unlimited since a delivery default literally means no supply is available in the spot market at any price). This is the exact opposite of price risk, where the downside risk is limited (prices cannot go lower than zero) while the upside is unlimited (prices can theoretically rise to infinity). To be more precise, only a long position in the futures market creates infinite basis risk and then only in case of a contract delivery default. To see why, assume the long position is held for delivery of metal to be used to repay a private metal lease. When delivery on the futures contract is not available, the short metal lease position essentially becomes unhedged and price risk takes over, which as we all know is infinite in case of a short position. It may do a person no good to be a creditor of an infinite amount to one party while a debtor of an infinite amount to another party, unless all sides are prepared and able to make good on their infinite debts. In contrast, a short position in a futures contract will be absolved of infinite debts because the futures exchange will need to arrange intra-exchange settlements at some fixed monetary amount. In the case of monetary metals like gold and silver, unlike other commodities, Mr. Fekete claims that basis risk is especially acute due to gold and silver's unique monetary status because new supply cannot be counted on to eventually bail out shorts who need metal for delivery. This is the case since drastic monetary conditions are expected to result in gold and silver taking over the role of money and these monetary metals at some point will not be traded away for any future promise, especially fiat currency, regardless of how tempting. Another way to say this is if/when gold and silver become the only form of payment accepted for goods and services, gold and silver futures will be DOA since prices will no longer be denominated in some external currency but rather in gold or silver itself! As a result, metal required for delivery against a futures contract will only be attainable by providers of valuable goods and services (which presumably excludes the financial intermediaries who maintain most of the short positions in gold and silver). There is one problem that I can see with this argument -- not with respect to validity but rather outcome. If, as Mr. Fekete claims and as I also suspect to be at least partially the case, shorts in the futures market are primarily spreading their long exposure or deriving income from metal physically held in their own possession, there would in fact be enough gold and silver ultimately available for delivery even as spot prices approach infinity and the basis collapses. In such a case, the futures exchanges would become an efficient means to transfer staggering amounts of wealth from shorts to longs. That is, if default can be avoided. And of course since the "bull in bear's skin" shorts don't really want to give up their gold and silver, it is unclear whether it might not be better for them to let the futures exchanges go ahead and default. Later, they could always use the legal system and their political power to keep as much physical gold and silver as possible (in any case more than they are entitled to). On the other hand, there is the likelihood that the futures exchanges would simply go into liquidation-only mode at the slightest whiff of impending default. That is, the small guy will probably get screwed while the big fish get to have it both ways. Sound familiar? If not, visit some of my musings on the gold and silver ETFs. Okay, enough idle speculation, let's get back to our discussion of basis. I have informally been tracking the basis in gold and silver for the last few years but with current market developments such as the launch of gold and silver ETFs and the amount of fund money flowing into these markets, there is a possibility that sustained and significant changes in the basis may foretell impending and drastic changes in the market. So I have decided to start analyzing in detail the basis for silver. While the basis in corn or wheat is simply the difference between the local market price and the equivalent price on the futures exchange, the basis in monetary metals is a little more complicated. While a warehouse operator might work the current harvest or the next several crops, each of which will have its own basis, there is really only one basis we care about in the monetary metals. This is because the spot markets are dominated by New York and London and the futures markets by the COMEX in given contract months. Let's see how the basis might operate in the case of silver to see which measure of basis is critical. Suppose in June 2006 I acquire 5,000 ounces of silver in 1,000 oz. COMEX eligible bars at $10 per ounce, which at the time represents a 20 cents buyer's premium to the New York spot price. If I decide to have my silver professionally stored, I will immediately start incurring storage fees of 1% to 1.5% per annum based on the value of the stored silver. Let's say this is what I opt to do. But let's also say I don't like to pay storage fees and instead I'd like to see my silver generate income, encouraged as I am by Mr. Fekete's essays. So I decide to look out one year and notice that the July 2007 futures contract (the closest to one year from May 2006) carries a premium of 1% to 1.5% over the spot price (excluding the 20 cent markup that I paid). No good, I say to myself, since in one year I'll have paid the equivalent amount in storage fees. As I go closer or further out in time, I also notice a corresponding change in the futures price such that I cannot generate enough advantage to offset my storage costs. Disappointed, I conclude that the basis seems to offer me very little advantage as the market seems to be priced efficiently after all. But then I notice something -- just as Mr. Fekete says -- there are call options out there with active bids (buyer interest) seemingly far enough out of the money that silver prices are very unlikely to save them from expiring worthless. Yet speculators seem to want these options in large quantities. In fact, I can write a call option for $500 that carries a strike price of $11 and expires in 30 days or less, which is sufficiently out of the money that I can sleep at night. $500 happens to be 1% of the $50,000 I paid for my 5,000 oz. of silver. If all goas as planned, the call option I wrote will expire worthless and I get to keep the $500 premium as "income" on my 5,000 oz. of silver. And I can do this again and again throughout the year. The worst thing that will happen is that the price of silver will exceed the strike price of the call option, at which point I will either buy back the call option or allow it to be exercised, closed out or held for delivery. If the strike price is achieved, I will essentially have made 10% selling my 5,000 ounces of silver and I can immediately buy it back again to repeat the process. So. let's see, I make anywhere between 1% and 11% in 30 days (an annualized rate of 12% to 121%). If I make only the annualized 12%, the consolation prize is that I get to keep my silver. If I make more because I buy back the call option or it gets exercised against me, I lose my silver but I make up to 121% on an annualized basis and I can always buy more silver and do it all over again. And I can do the same thing with gold. Who says silver and gold generate no income?!? Okay, not so fast. There are other considerations such as the margin requirement that must be maintained on written call options plus there is undoubtedly going to be some slippage as trades are executed. On the other hand, this is something that can be done every month but one. Even though only the so-called "contract months" in silver and gold have enough trading volume and open interest to ensure liquidity and efficient pricing, the months do not overlap with the exception of December and only November is not a contract month. In silver, the contract months are January, March, May, July, September and December. In gold, they are February, April, June, August, October and December. So the returns I calculated above might in fact be close to achievable for an astute trader with a good broker or direct access to the trading floor. Besides being interesting, how does all of this relate to basis? Let me tell you. Writing call options is actually only one part of the trading strategy of many commodity pool operators, market makers and other futures market participants. These activities tend to be interwoven such that futures and options prices tend to influence one another as the sophisticated market participants take advantage of mispricing. As an example of this, if put options were being bid well above fair value by speculators, the market specialists would scramble to write those expensive put options and hedge with a combination of futures and call options. They would lock in a guaranteed profit regardless of what happens with prices. Such opportunities do not last long in the futures markets and certainly the average trader is not adroit enough to take advantage of them. Having established that it is possible to earn an income from writing call options expiring in 30 days or less against physical holdings of gold or silver, it stands to reason that a portion of call writing is being done for this purpose. Should this call writing slow down or cease for one reason or another, the reverberations to futures prices would be measurable. This is because premiums on call options would start to rise until market specialists looking to initiate short positions would be attracted to doing so via writing call options instead of short futures positions. This in turn would create ripple effects in many trading programs, the net result being that the basis would initially rise. Why rise instead of fall as Mr. Fekete predicts? Well, I did say initially. The rise would be due to less short interest since a significant seller (the writer of call options looking for income) would have exited the futures market. I believe it would take some time for the realization to set in with other market participants as to why the call option writers are no longer in the game. And as Mr. Fekete states, a prime reason might be the presence of consistent gains in their physical gold and silver holdings making it too risky to attempt generating income through call writing. Here's why. Remember that I said earlier that it would be no big deal if a written call option went into the money since the gold or silver could be replaced? Well, what if prices were so volative or supply so uncertain that this statement were no longer true? In that case, the risk of losing the physical position and not being able to replace it outweighs the lost income that could be generated. When this point is reached and more and more market participants start to realize it, futures demand (long interest) could start to evaporate while supply (short interest) could grow precisely at the same time that the opposite is happening in the cash market. Another way to say this is that paper would be spurned for the real thing and futures prices could actually fall or more likely fail to keep pace with the exploding cash price of silver and gold. If all goes according to theory, the basis will predict these events. More specifically, the basis represented by the spread between the cash price of gold and silver and the futures price in the nearest contract month is what will sound the alarm. This basis can be measured in absolute terms or more usefully as a relative basis which is measured in terms of days to option expiration where a 10 cent absolute basis with 5 days to option expiration equals a 2 cent relative basis. At least that is the theory. It sounds pretty solid to me and that is why I started to look closer at the basis and to track it daily on the website. Soon I will also carry charts tracking the basis historically as well as provide further analysis. In the meantime, remember that the likely sequence of events before a plunging basis is a steep, temporary rise in basis. Also remember that the basis will not plunge without all sorts of other signs throughout the global economy that the public (or at least the wealthy) is losing faith in paper-denominated assets. Remember too that in silver the basis is measured as the difference between the cash price and the futures price of the nearest contract month with active options. For example, In June 2006 the basis would use the July 2006 contract but come July it would become the September 2006 contract. Therefore, we will consider the silver basis "dead" when call options in the nearest contract month are more than 30 days from expiration. When the silver basis is "dead", the gold basis is "alive" and vice versa except for the month of November when both the silver ang gold basis are "alive". Lastly, let's note that the current reduced basis in silver futures is probably an anomaly and not necessarily related to the imminent delivery default which Mr. Fekete warns about. For delivery defaults to be a near-term possibilty, the basis would have to fall consistently across all time frames in the same manner that lease rates would need to rise in unison. The interesting thing about the basis is that it is not an all or nothing proposition -- it should hold true in market gyrations of lower amplitude and thus I intend to incorporate it into my overall analysis of the silver market regardless of how far away we might be from financial Armageddon. In closing, I would like to thank Mr. Fekete for his invitation to start thinking more about the basis because although it is not currently telling a tale of a silver market about to be cornered, it could very well do so at some point in the future. Therefore, effective immediately, I will take up his challenge and start displaying and periodically analyzing what the basis has to say about the silver market. I presume others will follow including those who prefer to focus on gold (which is currently showing a very robust contango, by the way). Copyright � 2006 SILVERAXIS.COM All Rights Reserved

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