Silver Short

The Average Reddit Pissed Off Investor (ARPOI) has woken up to the silver short, and shifted their target from GameStop (GME). Allow me to explain a bit of Wall St geekery.

Also you can read this post here for some expected Wall St shit-baggery.

A good analogy might be if you co-sign for your child’s college loan. They take on a huge liability, graduate, can’t get a job, it defaults to your responsibility, you get a pay-cut at work and can’t pay both the mortgage and the student loan, you default on the student loan, that makes your risk-premium go up because your credit rating took a hit, then your adjustable-rate mortgage climbs and now you can’t afford to pay that either, so you lose the house but you still have expenses and the non-dischargeable student loan your kids took hanging over YOUR head. So now you and your kids have to move into your parents’ place, which increases their costs, and they start going through their retirement savings even faster than expected, grandpa has retirement money invested in student loans, and they cannot afford their rent any more, either…..

The current hedge-fund short interest in the silver market are the kids with the loans. The investment banks bankrolling them are dad. The bigger insurers and mega-banks are grandpa. They have the money, but they don’t have the silver.

How this looks in the financial markets:

In the stock market, a “Call” option is a contract that gives the holder of the contract to buy a stock by some future date at a fixed price. A “Put” option gives the contract holder the right to sell the underlying stock at the fixed contract price. These items are called “derivatives” because their price is derived from the underlying stock price. The price of the option is based upon the strike price, the expiration date (typically the 3rd Friday of the month, but there are also quarterly dates, see here), and the current stock price. Oh, and each contract represents 100 shares of stock. (blog post on shorts blowing up and how “shorting” can incur losses of more than 100% here).

Example: Microsoft stock is a stable, dividend-producing stock of a large company. It’s prices has varied between $200 and $240 per share in the last six months, and is currently (as of this writing) at about $232. You would not expect it to go above $250 any time soon, or below $200 any time soon. So if you think the price will rise dramatically in the near future, and you wanted to buy a contract to buy Microsoft MSFT at a “strike price” of $250 by the end of next month (a 8% move in a month) it will cost you a lot less than a one for $240 by 16Jul2021 (3.5% in six months), but also less than one with a strike price of $220 by Feb 19th, because the latter is “in the money”, meaning it is a contract buy price below the current market price. OTOH it will cost much more than a six-month expiring $350 strike price option because that big a price move (51%) is so unlikely. The “put” option is similar, but it’s a bet the price will fall. Say you currently hold 100 shares of MSFT stock, and you think the price will go down. You could buy a “put” with a strike price of $230. If MSFT rises, you do nothing and the option expires worthless and you are out the purchase cost. But say the price falls to $195, which is $35 per share below your strike price; now you can exercise the option and force the counter-party to your contract to buy the shares you hold at $230 each and walk away. Or you sell the “in the money” contract to someone else and pocket the cash, or exercise it and then immediately buy back your 100 shares of MSFT at $195 and end up with the same shares you had to begin with, but 100x$35 = $3,500 extra dollars in your pocket. If you expect the price to rise you can “write” a put that you expect to expire worthless for the other guy, and if you expect the stock to fall you can “write” a call the same way, in order to make a little side-money on stock movements without actually buying or selling the stock.

In other words, it’s a way to hedge your holdings with legalized gambling. The problem is that big players can push the price around without regard to fundamentals (or with inside knowledge) to ensure that THEIR calls and puts almost always win. So they can write HUGE volumes of these sorts of contracts, and like “the house” at a casino they win a consistent percentage and hoover up money from all the other players. Oh, yes, also note: not all of these contracts are “over the counter” and out in the open; some are privately arranged between two private parties.

OK, now on to “futures.”  Futures are similar, but they are on commodities like cattle, pork bellies, metals, or orange juice. They are not just on the paper of company stocks, they are based on physical items that are deliverable. The contracts are to either provide, or to take delivery of, said commodity. They can also be settled for cash, of course. If some normal hedge-fund dude bought a full silver contract (5,000 troy ounces, about 155.5 kg; note: all precious metals measurements are in “troy ounces,” or in grams / kilograms) with a strike price of $20 back when the price was $15 last March for $.50 an ounce. The contract cost him $.50/oz x 5000 oz = $2,500. The current price is about $27/ oz, He could simply settle the contract for cash and pocket the (($27 – $20 – $.50) x 5000 = $32,500 ) and call it a very good day. OR he could pony up another ($20/oz x 5,000oz = $100,000 dollars) and TAKE DELIVERY of something worth $27 x 5000= $135,000. If he does this, the counterparty to the contract is obligated to actually secure 5,000 oz of actual metal and arrange for delivery with you. You might send an armored car, you might send your nephew in a pickup. Work it out. (Of course, if he held 5 options in this scenario, he might sell four for cash, then use the profits from that to pay the price and take delivery on the last contract….. I’ll leave it as an exercise for the reader to ponder how many players in the markets have many contracts to work with, and what effect that might have.)

But taking delivery has to have actual metal involved. If the counter-party doesn’t have it already in the CME vaults and properly accounted for for delivery (some notes on that here) then they have to buy it on the open market, or by taking delivery on one of their own contracts. The problem is that there are contracts for well over 100x the actual amount of silver available for delivery in the vaults. Some contracts are held by banks, and are nothing more than paper hedges by manipulators; they have no interest in actual delivery. Some are going to be bets in the opposite direction that will not be exercised because they have negative value. But a not insignificant number are from companies that actually use silver, and NEED deliverable silver to stay in business. If the price on these contract holders start to think there is a problem with actually being fulfilled, they may start demanding delivery before expiration (technically they can do so at at time, according to the current rules as I understand them). Normally in a very wild month barely 1% of contracts are actually delivered on. If demand for physical spikes by retail silver investors, then demand for filling contract by mints to manufacture it spikes, the price rises, and more contracts are “in the money,” that is they are profitable to exercise for cash or to take delivery on.

If there is suddenly a spike in actual deliverable contracts, these cannot simply be papered over and paid off. Annual silver production is 800-900 million troy ounces.   Call it an average of 70,000,000 oz a month, or 14,000 full futures contracts. The “open interest” on the CME is about 179,000 contracts, or roughly a year’s production. Current registered silver on hand, all locations, is less than 150M oz, and that includes things that are being held for people already with no contracts attached, etc.; that is NOT all available to deliver (another category is “eligible,” but for futures contracting purposes you can pretty much ignore that). The CME is only one of several commodity exchanges in the world. If each of the ~6M reddit investment forum readers go out and buy 10 oz of silver (current price at retail ~$280 to $350 because demand is driving it above spot price), that is nearly an entire month’s production for the entire world. Manufacturers who use silver cannot make product without it, so they’ll move to take delivery earlier, further increasing demand for deliverable and putting more contracts “in the money.” This added demand spiral pushes the silver price higher. Even paying off the contracts that don’t want delivery gets rapidly more expensive, and the parties who are losing money will seek to raise cash to close them out, meaning they’ll have to liquidate other assets or call in support from bankers, which will have to get cash from somewhere. But cash only goes so far. If holders of a contract demand delivery, you can’t just cut a check… you have to drive a truck-load of metal somewhere. And you can’t pull accounting tricks to “fake” a few tons of metal to a manufacturer who is minting rounds, making film with silver halide, pumping out silver jewelry, fabbing electronics or solar cells with significant silver content. You need the physical metal. This circle of physical demand creating more physical demand can spiral out of control very quickly, and historically the CME has change the rules to favor the big guys and force cash settlements (for some parties), so the silver price is not allowed to accurately reflect the underlying fundamentals.

But for most people in the investment world, even the little guys on reddit, $350 is chump change. What if they all go for 100 ounces instead of 10? That’s more than 8 months total world production! The cascading series of counter-party obligations start melting fuses in the financial markets and will make some of the “edgier” players default, resulting in a cascade of bad news, new defaults for players higher up the chain, etc. Oh, remember that there are contracts that are not public? Yeah. Can you say “unmarked minefield?”

Now theoretically the big guys could change the rules and force everyone to make it all paper transactions, except for known manufacturers with regular deliverable contracts history. But the manipulations will need to be so egregious, epically huge, and flagrant that even a lot of average guys will feel totally cheated, and be ready to burn the whole thing down. What’s the point of maintaining “liquidity” and “institutional stability” if that means nothing more than continuing the rigging by the billionaires to screw the little guys? There are a tremendous number of people waking up and being ready to put up a bit of FU money to burn the whole thing down, let the chips fall where they may, while miners and mints have a lot of contracts they can exercise. And that is where we are now: the kids with the student loan holding a gun (buying silver) to grandpa’s head and saying “go ahead and make the bank collect on my student loan, old man! Go ahead! Dare you! Feeling lucky?”

(For those of you who found this useful and like reading books, please consider the titles listed to the right, or dropping a few bucks in the tip jar. Thanks for your support)

For you, the small investor: buy some physical silver if you can – 1 oz rounds and 10 oz bars are a good way to start. If you can’t find any without a ridiculous markup, but you do have a stock trading account, you might want to consider PSLV, a fund that buys and hold physical silver which is not leveraged and is audited regularly. As always, do you own due diligence before buying anything, and I am not a registered investment advisor.

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