Gold & Silver Trading Alert: Silver’s Physical Premium Soars

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Briefly: In our opinion, short (full) speculative positions in gold, silver and mining stocks are justified from the risk/reward point of view.

The recent sharp decline was accompanied by a significant increase in the premium that one has to pay while buying physical silver. If the physical market is getting very tight and dealers are really running out of silver, then this might be the final chance to buy the white metal before it really takes off.

If – that is the key word in the above paragraph. The critical thing to keep in mind is that it is not only the physical tightness that can make the premium over the spot increase in a visible way – the same is the case with price volatility during declines.

We have just been asked the question about the above and since nothing changed on the market from the technical perspective based on yesterday’s and today’s pre-market trading (if you haven’t read yesterday’s or last Wednesday’s alerts we recommend that you do so today – the points made in them remain up-to-date), we will dedicate today’s alert to providing a more detailed reply and explanation.

The question:

Dear PR,

Along with (I'm quite sure) many others, I have been waiting for silver to decline further before adding to my physical supply. Within the last week or so, I have noticed the following:

1. 90% 'junk' US silver coins - premium has increased from $3.99 over spot to $6.00 over spot; some denominations unavailable, or available only in mixed bag quantities.

2. US silver eagles - premium has increased from the long-standing $2.00 over spot to $3.29 over spot. No shortages apparent (yet).

I can only imagine the premium increases if silver gets to $13.00 or below. The above changes, by the way, represent three major brokers in different parts of the US, so they seem pretty solid.

(...)

Any thoughts about this situation? I know you are pretty firm in your belief of another major drop, but assuming that happens, might we be past the most cost-effective point to accumulate physical?

Keep up the good work.

Our reply:

Thank you for your question. We saw a similar thing in the early days of the 2013 decline as well. The premium over the spot rose when the volatility increased. We commented on it on April 25, 2013 and on April 19, 2013 . Many market commentators wrote that this means that the decline is artificial, that the physical market disconnected from the futures market and that there were very bullish implications. We wrote the following:

(…) because people view this decline as very temporary and because there are quite significant transaction costs. The decline was very sharp, the fundamentals remain in place, and those who bought physical metals most likely did so based on the fundamental situation. If the price of gold stays low for longer, the physical market will likely slowly start to reflect that. If it doesn't change for months, then it will be a strong signal to get back on the physical side of the market as it will mean that prices simply won't go lower. At this time, however, this is a short-term phenomenon, something that could be explained with just the above.

If dealers also view the drop as temporary and they had built their inventory previously then it's not surprising that they don't want to sell at a loss if instead they can just wait it out. Again, if prices stay low for some time the premium will likely decline, as dealers either (1) run out of cash and are forced to liquidate their inventory, or (2) they see that they can either start selling or wait and perhaps sell at even lower prices. For now, both dealers and buyers seem to think that the drop in prices is only temporary, and they are taking this into account when making transactions - thus high premium over spot.

The temporary increase in premium didn’t make us bullish at that time and it seems that the above analysis was quite valuable - back then silver was at trading close to $24 - more than 50% higher than it does right now, so staying out of the market at that time proved to be a very good idea.

Therefore:

The increase in premium over spot is likely temporary and it’s likely to decrease as silver moves lower in a more stable way - and I expect it to move lower in a more stable way and then to end the decline in a very volatile fashion (it’s likely that the premium will increase once again at that time).
The increase in premium doesn’t imply that a major turnaround is just around the corner - it reflects the increase in volatility during the recent decline.
The premium might increase during the final decline in silver. However, there is a way to limit this effect and that is to buy silver temporarily (!) in a non-physical or (better) physical but electronic form that tracks the silver price more closely (without important moves in the premium over the spot).

Various instruments might be available to different investors, but in general, the main choices are: ETFs with physical backing, ETNs, and futures. The idea would be to purchase the above-mentioned instruments corresponding to the amount of metals that you would want to own and after silver moves back up and the volatility decreases (and premium over the spot in case of physical metals decline) to sell them and at the same time buy physical metal. The final result would be close to buying physical metals with lower premium instead of buying it at the volatility-driven, high premium over the spot.

Naturally, this would apply to investment and trading parts of the portfolio - in case of the insurance capital, we think that having physical metals at all times in this part of the portfolio is prudent.

Summing up, the situation in the precious metals market remains bearish and the increase in silver’s premium over the spot on the physical market doesn’t necessarily imply much higher prices in the coming weeks. In fact, it’s much more likely that it simply reflects the increased volatility during the recent decline, just like it was the case in April 2013. The outlook for the precious metals sector remains bearish. We will keep you – our subscribers – updated.

We will keep you – our subscribers – updated.

To summarize:

Trading capital (our opinion): Short position (full) position in gold, silver and mining stocks is justified from the risk/reward perspective with the following stop-loss orders and initial (!) target prices:

Gold: initial target price: $1,062; stop-loss: $1,208, initial target price for the DGLD ETN: $95.88; stop loss for the DGLD ETN $66.49
Silver: initial target price: $12.72; stop-loss: $17.11, initial target price for the DSLV ETN: $102.21; stop loss for DSLV ETN $38.32
Mining stocks (price levels for the GDX ETN): initial target price: $14.12; stop-loss: $18.73, initial target price for the DUST ETN: $30.68; stop loss for the DUST ETN $14.08

In case one wants to bet on lower junior mining stocks' prices (we do not suggest doing so – we think senior mining stocks are more predictable in case of short-term trades – we if one wants to do it anyway, we provide the details), here are the stop-loss details and initial target prices:

GDXJ: initial target price: $18.12; stop-loss: $25.78
JDST: initial target price: $16.26; stop-loss: $5.79

Long-term capital (our opinion): No positions

Insurance capital (our opinion): Full position

Please note that a full position doesn’t mean using all of the capital for a given trade. You will find details on our thoughts on gold portfolio structuring in the Key Insights section on our website.

As a reminder – “initial target price” means exactly that – an “initial” one, it’s not a price level at which we suggest closing positions. If this becomes the case (like it did in the previous trade) we will refer to these levels as levels of exit orders (exactly as we’ve done previously). Stop-loss levels, however, are naturally not “initial”, but something that, in our opinion, might be entered as an order.

Since it is impossible to synchronize target prices and stop-loss levels for all the ETFs and ETNs with the main markets that we provide these levels for (gold, silver and mining stocks – the GDX ETF), the stop-loss levels and target prices for other ETNs and ETF (among other: UGLD, DGLD, USLV, DSLV, NUGT, DUST, JNUG, JDST) are provided as supplementary, and not as “final”. This means that if a stop-loss or a target level is reached for any of the “additional instruments” (DGLD for instance), but not for the “main instrument” (gold in this case), we will view positions in both gold and DGLD as still open and the stop-loss for DGLD would have to be moved lower. On the other hand, if gold moves to a stop-loss level but DGLD doesn’t, then we will view both positions (in gold and DGLD) as closed. In other words, since it’s not possible to be 100% certain that each related instrument moves to a given level when the underlying instrument does, we can’t provide levels that would be binding. The levels that we do provide are our best estimate of the levels that will correspond to the levels in the underlying assets, but it will be the underlying assets that one will need to focus on regarding the sings pointing to closing a given position or keeping it open. We might adjust the levels in the “additional instruments” without adjusting the levels in the “main instruments”, which will simply mean that we have improved our estimation of these levels, not that we changed our outlook on the markets. We are already working on a tool that would update these levels on a daily basis for the most popular ETFs, ETNs and individual mining stocks.

Our preferred ways to invest in and to trade gold along with the reasoning can be found in the how to buy gold section. Additionally, our preferred ETFs and ETNs can be found in our Gold & Silver ETF Ranking.

As always, we'll keep you - our subscribers - updated should our views on the market change. We will continue to send out Gold & Silver Trading Alerts on each trading day and we will send additional Alerts whenever appropriate.

The trading position presented above is the netted version of positions based on subjective signals (opinion) from your Editor, and the Tools and Indicators.

As a reminder, Gold & Silver Trading Alerts are posted before or on each trading day (we usually post them before the opening bell, but we don't promise doing that each day). If there's anything urgent, we will send you an additional small alert before posting the main one.

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