Silver Set for Retreat

President's Day represents the last of the New Year holidays. The current setup in the silver futures market looks like it may be the last holiday for speculators whose positions are quickly piling up on the long side of a market that is already significantly overbought. We'll examine the case for a holiday driven speculative washout and reset in the most speculative of the metal markets.

Silver has rallied about 20% since its Christmas low. Since then, speculators in the silver market added more than 20k contracts to their net long position. In fact, the last time the speculators' net position was this bullish was in September when silver last traded near $20 per ounce. Perhaps, most importantly, speculators set their net long record position in late August of last year as they tried to push the market higher. Note that this ended abruptly at the downward sloping trend line and the market failed, washing out the long speculators' collective position through the end of the year.

There are multiple ways to read the weekly Commitments of Traders data. We use it to define support and resistance as defined by the commercial traders. These are the miners pulling silver from the ground who sell the futures markets to hedge their forward production as well as the processors who buy silver futures for use in finished products. We track their actions on a relative and absolute scale to determine which group has the upper hand in the market. Silver miners are currently selling forward production at a much greater pace than silver processors are buying. Miners are anxious to sell the rally while processors are not worried about prices running away from them. This indicates that the commercial traders collectively believe the silver market to be overpriced.

The commercial traders' total position is approximately 50% larger than the speculators'. Therefore, we use the support and resistance created by the commercial traders to create swing trading opportunities. We look for markets that have become overextended due to a speculative build in positions. Once we've identified this unsustainable market condition, we look for an entry opportunity and expect to profit as the market returns to its value area and the speculative position resets, and the process starts over.

Looking at the weekly silver futures chart below, you'll see our proprietary COT Ratio indicator. This is one of the tools we've developed to help determine the sustainability of a move. The green line in the bottom subgraph depicts Dollars long vs. Dollars short for the individual trader groups. Notice that the speculative COT Ratio consistently lines up with market peaks once it's greater than 4:1. We can see the market imbalance when we combine a speculative net position near its historical maximum with a COT Ratio that is also near the high end of it's scale all in a market that is already overbought on a weekly basis. When we throw in the overhead trend line resistance on a weekly chart, we have a full holiday alert on for a reversal lower in the silver futures.

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