Wednesday, April 17, 2013

Executive Summary:

I'm writing this on Friday, April 12th 2013, and gold and silver have just broken to new 12+ month low prices. I've been looking at the $21.50-$24 range for silver and the $1250-$1385 range for gold for quite some time now as a good place to buy. Since these markets can move fast when they want to, I expect the low in PMs could come as early as the next few weeks. I also have elevated my risk of catastrophic developed market bond market carnage to 20% in the next 6 months.

I'm not making any buying or selling recommendations here, and everyone must make their own investing decisions. Also, the most important aspects of financial prep are getting rid of debt and having a diverse array of investments from emergency preps such as cash to a diversified portfolio that can weather any storm. That being said, I am looking personally at the next days/weeks/months as a good place to buy some precious metals, and expect markets to get quite volatile for reasons I explain below.

The details:

Price falls in future markets can be exacerbated in two ways: future holders getting margin calls and having to abandon positions, and option hedging from large market participants. The option hedging is especially relevant right now because implied volatility has been so low, that there is a lot of gamma/delta hedging necessary. Delta hedging refers to selling futures to square up an option position so that the option player isn't long or short, and gamma hedging means squaring up an option position so that the option player isn't long or short volatility more than they mean to be.

When banks and other market makers sell options they wind up being short gamma which is the fancy word for volatility. This means that if prices stay more or less the same, they'll make money but if prices start moving quickly in one direction they lose money.

These options market makers don't usually want a directional position meaning they don't want to be long or short most of the time - they just want to be long or short (usually short) volatility. When prices start moving significantly in one direction, the "delta" of the options start to change - which essentially means that by virtue of selling a bunch of options they wind up also being net long if a market starts falling quickly or short in a quickly rising market. Since they don't actually want a directional position, they are forced to sell in quickly falling markets which exacerbates the move. Ultimately, they can get blown out of their position - which means in this case they would be buying puts into the teeth of a quickly falling market.

The fastest part of the fall then comes often just as they are buying puts - in order to find a willing seller (someone willing to take over the risk of selling these options they are trying to unload) they need to pay a huge premium. You can see this because implied volatility spikes in the markets just before the end of a selling wave. Once the big option sellers have unloaded their positions, the pressure from delta hedging is removed and the downward pressure on price stops. At some point you also have bargain hunters moving in to buy on the other side.

Long story short - we're in a liquidation phase right now so prices could move quite quickly down (as they did today) in an essentially forced move in the paper markets...BUT there is also tremendous interest in physical metals, particularly from Asian Central Banks so I would imagine there will be some massive support at some point - and it could get quite difficult to obtain physical metal (just like in 2008).

Just a heads up for everybody out there - don't be surprised if wait times for physical start getting ridiculous. You might consider buying from local sources where you can physically leave the store with the goods. I know the premium you pay tends to be ridiculous at brick and mortar shops but you might save a lot of heartburn - my guess is that well run places will just stop selling (because they won't have it) and dodgier places will continue to sell but with long delays (which is where the heartburn would come in).

Finally, I wouldn't be surprised if all market movements start getting a bit more discontinuous for two reasons related to the bond markets:

first, the Japanese bond market is looking very vulnerable - if JGBs (Japanese government bonds) go belly up then all of the dominoes start to fall.
second, Cyprus has destabilized the Euro-zone banking system and the jig could well be up there as well.

Both of these events have about a 10% chance of creating havoc in the next 6 months, so I'd put about a 20% chance on things getting out of hand before the end of the year. If either of these events occurred I seriously doubt the US could avoid the fallout because in both cases you would have a disaster in developed economy bond markets - and it would inevitably pop our own bloated and obviously untenable debt situation.

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