How to Profit from Investors' Mistake by Shorting Silver

04/12/2017 2:48 am EST

Focus: FUTURES

Landon Whaley

Editor, Focus Market Trader

For silver investors who prefer ETFs, you can short the silver market via the iShares Silver Trust ETF (SLV), Or you can execute silver trades using the futures market, asserts Landon Whaley, Founder and CEO of Whaley Capital Group.

Wayne Gretzky famously said, “I skate to where the puck is going to be, not where it has been.” Successful investing requires this same mentality.

Right now, investors are making a common mistake by extrapolating the current state of affairs into the future. Specifically, they are overly focused on the fact that global inflation has been raging to the upside. I can’t say it more plainly: economies and markets don’t go straight up or straight down. Rather, they are cyclical.

Inflation has awakened from its post-Crisis slumber but it’s not going to continue to accelerate month after month until the end of time.

Global inflation has been ripping higher since August 2016, largely due to the price of crude oil doubling in the first half of last year. Since then, oil has traded sideways, which is the most critical factor impacting the near-term direction of inflation.

Unless oil breaks above $55 a barrel on a sustained basis, then inflation will continue to rise briefly from here, but begin falling once the translation effects of the price spike in crude and other commodities begin to subside.

This inflationary slowdown is already impacting the Eurozone, where core inflation in March fell to the lowest level since 2015. This dramatic slowdown was driven almost entirely by lower energy prices. But this isn’t just about the Eurozone, inflation expectations have been falling for months in other economies like: United States, Canada, Japan, and Mexico, to name a few.

Silver Bells, Hear Them Ring

My process is rooted in evaluating markets using my Gravitational Framework, which helps me better understand the three most critical forces, or gravities, that impact asset prices: fundamental, quantitative, and behavioral.

Once the reflation trade unwinds, there are many markets that will turn as ugly as a 60-year-old man in an Ed Hardy T-shirt. But there is one market that is particularly poised to get rocked.

Silver has been a huge beneficiary of the recent inflation spike. Despite getting no press, silver was the best-performing global market in the first quarter--but that is all about to change.

Fundamental Gravity Says What?

Given the fundamental backdrop of accelerating growth and inflation, silver’s 15% year to date gain isn’t surprising. However, that gain is nearly twice the average quarterly return experienced in an economic environment characterized by growth and inflation moving higher in lockstep.

But the shine shouldn’t attract you. In fact, it’s an understatement to say that the recent silver rally is long in the tooth. If the coming inflation slowdown is accompanied by slowing growth, then we will enter a fundamental environment that is silver’s kryptonite.

Quantitative Gravity Says What?

Quantitatively, silver failed again last week (the week of April 3-7), for the second time in a month, to break out above a critical price level of $18.46. Since trading below that price on October 3, it has managed to close back above that just three times in the last six months. That price is clearly silver’s glass ceiling, until further notice.

Not only do we have a solid line of resistance overhead, but silver has a negative correlation to the USD across multiple durations.

This is a big problem for silver bulls because despite the USD’s weakness to start 2017, it remains bullishly positioned. The revival of the “policy divergence” trade makes it very likely that the greenback will hold above both the quantitatively critical level of $97 and the psychologically critical level of $100.

It’s not just silver’s Fundamental and Quantitative Gravities stacking up on the bearish side of the ledger. The Behavioral Gravity is also tilted bearish, because investors remain blissfully unaware of inflation’s impending peak.

Behavioral Gravity Says What?

Speculative positioning in the silver futures market is leaning to the long side near a three-year high, while short positioning is at an 18-month low.

The options market is confirming this extremely bullish bias because for some reason, investors are expecting less volatility over the next month than what is currently being experienced day-to-day.

This combo platter of behavioral data tells me people are not only uber-long this market, but overly complacent as well.

The Trade Idea

From a short-trading opportunity perspective, it doesn’t get much more appealing than what I’m seeing in the silver market. Despite silver’s Fundamental Gravity shifting from bullish to bearish, silver is still being priced at level commensurate with a bullish Fundamental Gravity and not fundamental kryptonite. Not only that but despite a 15% gain in 3 months, investors are still leaning extremely long and complacently expecting low volatility for the foreseeable future.

For investors who prefer exchange-traded funds, ETFs, you can short the silver market via the iShares Silver Trust ETF, SLV (SLV). You can initiate new short trade ideas between $17.26 and $17.87. Depending on how much room you want to give this trade to move, you can use a risk price between $17.41 and $18.31. If SLV closes above $17.90, then you should exit any open trade ideas.

Chart

For many reasons, including liquidity and nearly 24-hour trading, I prefer to execute silver trades using the futures market. If you are an investor who is comfortable with these types of trades, then you can execute this short trade idea using the silver futures contract with the most daily volume.

Currently, the contract with the best liquidity is the May 2017 contract. You can initiate new short trade ideas between $18.35 and $19.06. Depending on how much room you want to give this trade to move, you can use a risk price between $18.54 and $19.66. If the May 2017 contract closes above $19.06, then you should exit any open trade ideas.

Bottom Line

Clearly, most of the world isn’t prepared, but if you “skate to where the puck is going to be, not where it has been,” you will not only sidestep danger, but also position yourself for opportunities most investors never see coming. As always, stay data dependent, process driven and risk conscious, my friends.

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