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June 24, 2005

Trading Silver Volatility
by Adam Hamilton

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
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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