Trading
Silver Volatility
Adam Hamilton
Archives
Jun 24, 2005
With all the excitement surrounding
the new all-time euro
gold highs lately, silver has taken a back seat in the popular
precious-metals consciousness. But quietly, behind the scenes,
silver bullion is being increasingly accumulated by savvy investors
around the world.
Just last week Barclays Global
Investors submitted an application to the US SEC for an exchange-traded
fund that tracks silver. Since silver is such a tiny market,
even a modest inflow of traditional equity capital into a silver
ETF could exert great upward pressure on the silver price. If
investors bid up a silver ETF the underlying trust is forced
to buy silver bullion to maintain the ETF's tight tracking of
silver prices.
I am planning on analyzing
the coming silver ETF in particular and commodities ETFs in general
more in the future, but the potential silver reaction to its
first ETF in the States got me thinking about silver volatility
this week. I've been curious about silver volatility trends for
some time now and finally got around to investigating.
Volatility is one of the greatest
technical tools available to investors and speculators. The emotions
of greed and fear echoing through the thundering herd of market
participants are responsible for most short-term price action,
and more than any other technical tool volatility indirectly
quantifies these ethereal driving forces.
In stock-market analysis specialized
volatility tools such as the VIX are used extensively, and often
very successfully, by traders. In the stock markets high volatility
is a sign of fear while low volatility is an indication of greed
and complacency. As all contrarians know, excessively
high volatility usually portends a major rally to bleed off
oversold fear-laden conditions while excessively
low volatility is often a harbinger of a major correction
to rebalance greed-drenched overbought levels.
Volatility is a great emotional
proxy because most market participants refuse to take the hard
path of training themselves to trade without any emotions. When
people are scared they tend to sell first and ask questions later,
and folks are naturally inclined to grow most scared right at
major interim bottoms. This frenetic trading spawns great volatility,
thus in the stock markets high volatility is a sign of a low
being carved.
Conversely when stock investors
are euphoric and complacent they tend to reduce their trading
considerably, just coasting along for the ride. While they triumphantly
bask in their unrealized gains (due to their own brilliance of
course) they feel no pressure to buy or sell so prices meander
lethargically. Thus low volatility is a signal that the markets
are topping. Case in point is the hyper-complacent
US equity markets today.
All this is stuff is very elementary
for the stock markets, volatility has been studied for centuries.
But even several years into our new secular
commodities bull, I have yet to see any significant application
of volatility studies to commodities investing and speculation.
Presumably commodities volatility works like stocks volatility,
but we need to know for sure before we start using it as a trading
indicator.
Silver, with its trivial little
market size and timeless speculative appeal, has long been one
of the most
volatile of all the major commodities. It doesn't take much
capital to move silver since its market is so small and speculators
flock to this volatility like moths to a flame and amplify silver's
gyrations, probably to a greater degree than in any other major
commodity. Thus, silver seems to be an ideal place to launch
commodity volatility studies.
Without any established volatility
tools like the VIX to work with, I decided to use a methodology
similar to the one discussed last month in SPX
Volatility Trends. We looked at the last decade of silver
prices on an interday, or closing-price-to-closing-price, basis.
Then we quantified the number of days that ran 1%+, 2%+, and
3%+ absolute interday volatility.
These days are then charted
on a rolling-month basis. Since an average calendar month has
21 trading days, we centered a 21-day window around every trading
day of the past decade or so. A red spike to 8, for example,
indicates that on that particular trading day there were 8 days
where silver had 3%+ interday moves within 10 days before to
10 days after the day with the red spike to 8.
While no doubt primitive compared
to sophisticated stock trading tools like the implied volatility
indexes, at least this simple approach gives us a rough visual
approximation of silver volatility trends. Before this analysis
I figured that commodities volatility would look and work just
like stock-market volatility. Now I am not so sure though. These
results are very fascinating as they are not what I expected.
In the stock markets, recall
that volatility tends to be the highest near major interim bottoms
and the lowest near major interim tops. And obviously the same
types of emotional humans with greed and fear perpetually warring
in their hearts trade silver as trade stocks. Not necessarily
the same individuals, but the same chronically emotional humankind.
Thus, greed and fear in silver ought to manifest themselves in
volatility terms in similar patterns to what we witness in stocks,
right?
Apparently not. Leave it to
the perpetually fascinating markets to yield silver volatility
data 180 degrees out of phase with expectations! As you drink
in the chart above, note that the big red and yellow volatility
spikes tend to cluster around interim tops in silver. Similarly
lower volatility times where yellow and red data wanes tend to
occur near interim bottoms in silver. What is this madness? I
kind of wish I could tell you the data is bad, but it is not.
Multiple analyses on different silver datasets yielded the same
curious phenomenon.
Adding to the mystery, the
decade or so above encompasses both bull and bear markets. Silver's
current secular bull didn't launch until late 2001 just as the
restless metal threatened to plunge under $4. Before that it
languished in a long multi-decade secular
bear along with just about every other major commodity. The
sharp spike in late 1997 and early 1998, incidentally, was a
bear-market anomaly that offers excellent insights into silver's
extreme volatility.
In the summer of 1997 as silver
threatened to fall to $4, legendary contrarian investor Warrant
Buffett started layering in a massive silver position, reportedly
129m ounces. The silver market is so small and illiquid that
Mr. Buffett's purchase started moving prices. And once news of
his buy leaked, speculators stampeded in to follow the Sage of
Omaha's lead.
Even though the absolute amount
of capital involved was trivial compared to the stock markets,
silver soared. From July 1997 to February 1998 it blasted 85%
higher in an impressive speculative spike. While this mini-mania
was short lived and the secular bear resumed in subsequent years,
it really illustrates just how fast silver can jump if any material
amount of outside capital grows interested enough to bid on it.
This is why I am so excited about a silver ETF opening a new
back door for equity capital to deluge into silver.
In this chart, we see high
interday volatility in the silver record during both sharp bear-market
rallies and sharp bull-market uplegs. Volatility is also low
near lower silver price points in both types of markets, although
it is much more pronounced visually in the new bull stage. In
the final years of the secular bear including 2000 this relationship
didn't hold as silver volatility fell off the map yet the silver
price kept grinding lower into late 2001.
Nevertheless this inverted-volatility
long-term phenomenon is really contrary to expectations and stock-market
wisdom. Rather than getting scared near interim bottoms and driving
volatility higher like stock traders, silver speculators seem
to just get plain bored and walk away rather than worrying. And
instead of growing complacent near tops and forcing volatility
lower like the stock guys, the silver crowd seems to get whipped
into a speculative frenzy and bids like crazy whenever silver
spikes sharply.
With silver now in a secular
bull market, I wanted to zoom in to the past several years or
so to more precisely quantify these odd volatility signatures.
If silver volatility consistently seems to work in this inverted
manner in our bull to date, then odds are it will continue to
persist into the future. And if it persists, then we can add
silver volatility to our trading-tool arsenal to help define
high-probability points to throw long or short the restless metal.
To better quantify the silver
volatility extremes I set some arbitrary boundaries. In the following
chart low volatility events are considered to be any volatility
lull that collapses to 7 or less 1%+ days per rolling month.
I considered high volatility events to be any volatility spike
that witnesses 4 or more 3%+ days per rolling month. Interestingly,
even though backwards by stock volatility standards, silver has
been remarkably consistent in its volatility peculiarities.
At this chart scale encompassing
the silver bull to date the same volatility patterns witnessed
in the long term chart are evident. High silver volatility is
likely to cluster around interim highs in silver while low volatility
is most often witnessed near interim lows. Even though contrary
to stock-market experience, I think these volatility signatures
are certainly tradable.
Starting with the lows, when
volatility wanes under 7 or less 1%+ days per rolling month,
reveals excellent consistency across nine such separate events
in this silver bull to date. Vertical green lines are rendered
between the silver volatility lows and the corresponding blue
silver prices. If you examine all of these events, you will note
in every case that silver tends to be low relative to its surrounding
prices when a volatility low occurs.
Sometimes these volatility
lows are nearly perfect silver buy signals. For example, lows
four, five, and six above each marked fantastic opportunities
to throw long for the biggest silver upleg in this bull to date.
Low eight this year also marked nearly the ideal time to go long
silver again following its sharp
correction in late 2004.
Other volatility lows, like
two and seven on this chart, don't correspond precisely with
silver interim bottoms but they certainly still indicate an excellent
general season to be long. While silver briefly went lower after
both two and seven, in a matter of months it was trading significantly
above the signal levels. In each case, even when the volatility
lows didn't exactly match the silver price lows, silver traders
could have done very well by throwing long on low volatility
events, 7 or less 1%+ days per rolling month.
Silver's volatility highs,
defined as 4 or more 3%+ days per rolling month, were not as
precise as the volatility lows but still offer valuable insights
to silver investors and speculators. Bull to date there have
only been four such events and they have all transpired since
early 2004.
Volatility highs one and three
above occurred as individual silver uplegs were about two-thirds
of the way to reaching short-term maturity before correcting.
Number two occurred during a wickedly sharp correction early
last year while four happened after a sharp surge in silver topped
out earlier this year. While occurring at different times relative
to their respective spikes, these volatility highs all happened
near interim silver tops.
Volatility high two is the
most comfortable and familiar out of these volatility highs since
a massive volatility spike coincided with a sharp silver selloff.
This event is exactly like what we would see in the stock markets.
Silver speculators got scared early last year, they sold
off silver sharply, and the fear-driven volatility rocketed
higher. Thus, like the general markets, silver volatility highs
can sometimes mark great V-bounce buying opportunities.
But silver volatility highs
can also signal that a particular silver upleg is nearing its
terminal late stages, like one, three, and four above. In this
case, silver traders should be prepared to ratchet up their trailing
stops and be ready to bail out quickly if silver starts collapsing
sharply in a correction. In silver excessive volatility apparently
indicates irrational exuberance and the necessary ensuing sentiment
rebalancing that inevitably follows near-vertical spikes.
In light of these observations
silver traders should carefully watch for volatility highs, rolling
months where there are 4 or more 3%+ volatility days. The proper
course of action upon observing this event depends on its immediate
price context. If silver has just plunged sharply in a correction,
then odds are the volatility spike portends a classic equity-style
V-bounce, a long signal.
But if a volatility high occurs
when silver has been powering higher and has not just recently
fallen sharply, then odds are it is signaling that the end of
the particular sharp upleg at the time is drawing near. In this
context silver investors should not be buying any new positions
and silver speculators should be ratcheting up their trailing
stops, preparing to sell their silver calls, and looking out
for a sharp correction.
Thus the general idea here
is to throw long silver and silver stocks when silver's volatility
is low and prepare to go short when silver volatility is high,
unless there has just been a sharp correction in which case a
long-side V-bounce is probable. So far in this bull to date this
unconventional volatility strategy would have served silver speculators
very well.
While it's easy to follow a
mechanical trading strategy, it is hard to discern why the strategy
actually works, especially in this case which seems to defy conventional
volatility-based trading strategies. Although I am not sure why
silver's volatility signature is so different from stock-market
signatures, I have been pondering this quandary for a few days
now and have some tentative ideas.
Silver is a very small and
highly speculative market largely accessible for traders only
via futures. Until commodities gain widespread acceptance in
the coming years due to this ongoing secular bull, I would imagine
most silver futures trades are done by sophisticated players.
Futures guys who survive long enough to keep trading inevitably
learn to suppress their own emotions like all successful speculators,
so they are nowhere near as fickle as the general public investing
in stocks.
If silver is largely professional-trader
driven, then it may make sense why its volatility signature seems
so inverted. Professional speculators live for momentum, they
follow trends and ride them to maturity. When momentum fades
from a market, they tend to abort their trades and move on elsewhere.
Most of these folks couldn't care less in what or where they
trade, they just want fast moving markets so they have more chances
to earn big profits.
In silver's case, silver's
volatility may be low near its interim bottoms because at these
lazy lows professional traders are the least likely to notice
it. When silver languishes near interim bottoms its momentum
is usually gone so it makes little sense for a professional speculator
to let capital go stale in silver. With capital elsewhere while
silver bottoms, its price remains relatively stable gutting its
volatility.
Conversely when silver starts
soaring in a dazzling new upleg, the futures guys start taking
notice. If they perceive the momentum as sustainable, some will
pile in driving the silver price higher. And since nothing begets
popular interest and higher prices like rising prices, the flood
of speculative capital chasing silver forms a short-term virtuous
circle. Silver is bid higher enticing in more players, and the
added capital buffets its price around more than usual driving
up its volatility profile.
If this thesis is correct,
and it may not be, then silver's volatility signature would probably
change once the general public gets involved in silver down the
road. At some point in this commodities bull odds are the generally
more emotional small investors will outnumber professional futures
players. And if the silver ETF is a success, then it won't take
long at all for dumb capital to dominate smart capital as an
equity back door shunts traditional stock capital into silver.
And once small emotional investors
command a dominating share of silver trading, then I suspect
we have a good chance of seeing silver volatility reverting to
more of a conventional stock-market-like profile. This would
lead to silver volatility spiking higher near major interim bottoms
and grinding lower near major interim tops. If you actively trade
silver futures, you ought to keep this in the back of your mind
in the coming years.
Silver, even with its current
decidedly unconventional volatility profile, definitely seems
tradable on volatility. In fact, silver's latest major buy signal
in volatility terms is triggering right now. If the future holds
true to recent precedent, silver should be in for another very
profitable move higher soon here.
At Zeal we have been anticipating
this probable silver surge due to other
technical considerations and have been gradually layering
in new silver stock and silver-stock options trades. If you are
interested in our current real-world silver-oriented trades carefully
chosen for their potential to leverage a new silver upleg, please subscribe
to our acclaimed Zeal
Intelligence monthly newsletter today.
The bottom line is today's
silver volatility signature is signaling higher silver prices
ahead based on bull-to-date precedent. While silver's volatility
signals are certainly not conventional by stock-market standards,
they have been very consistent bull-to-date and there is no reason
to think they are due to dramatically change soon.
Low silver volatility like
we are witnessing today has been a reliable indicator of higher
silver prices being imminent. And when the silver prices start
rising and professional futures traders chase the momentum, both
volatility and prices should accelerate higher.
Adam Hamilton, CPA
June 24, 2005
Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!
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