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Basis
is the spread between the spot price (cash,
physical or local price) and the futures price of
a commodity. Basis is important primarily
in agricultural and other markets where
product warehousing serves to balance supply
and demand. Because the warehouse operator
can deliver product to, or withhold it from,
the market when there is a wide disparity
between the local or current price and the
exchange-traded, futures price, the basis
can be said to measure the efficiency
and effectiveness of the markets.
Ideally,
the basis represents the
holding or transportation cost of a
commodity allowing for a small warehouse
profit. Otherwise, the arbitrage profit
opportunity will be tempting to enough warehouse
operators who will compete in the market
until excess profits are reduced and the
basis returns to near ideal levels. In actual
practice, basis may temporarily shrink or grow in reaction
to supply and demand in both the spot and
futures markets as markets are never 100%
efficient.
So
what do different levels of basis indicate?
All things being equal, the normal condition
for a commodity is to have
a positive basis where the futures price
is higher than the spot price. This condition
is called contango, which can be viewed
as the cost to carry a commodity in
inventory including storage fees, insurance
and interest plus cost to transport to market. The reason contango is said
to be a normal condition is because arbitrageurs
can usually make risk free profits when
contango is significantly different from
the carrying cost. They do this by trading
the price spread between the spot delivery
month and the future delivery month whose
price is out of whack. For example, if contango
is too high, an arbitrageur can buy a commodity
in the spot month and immediately sell a
contract in the futures market at a price
higher than the spot price just paid plus
the costs to store and transport.
As long as the carrying cost is fixed (sometimes
it isn't, and this itself can cause changes
in the basis), the arbitrageur will have
locked in a risk free profit. He or she
can repeat this trade as long as the contango
remains too high, but eventually the
excess spot demand and excess futures supply
will reduce contango to a normal level.
The
opposite of contango, backwardation, happens
when the futures price is lower than the
spot price. Backwardation indicates that
spot demand exceeds speculative expectations
for future prices and is usually associated
with markets experiencing what is assumed
to be temporary tightness in physical supply.
For example, backwardation has been a consistent feature
of energy markets for years thanks to the
peculiarities of energy supply (mostly due
to the manipulative acts of OPEC and
other command economy oil exporters as well
as the difficulty of above ground storage
of oil and gas). On the other hand, gold
and silver rarely ever experience backwardation.
That
is, until recently, when silver started showing
reduced contango and even moderate backwardation.
It
is too early to tell if this condition represents
a temporary spike in speculative demand
in the spot market resulting from unusually
large money flows (something I have
pointed out for months now using lease rates).
Certainly the silver ETF and its front runners
are expected to have a lot to do with this
spot demand for physical metal. Remember
that backwardation can occur simply due
to tight supplies and incessant demand (whether
fundamental or speculative in nature) in
the spot market. In fact, we can see plenty
of speculative behavior in silver lease
rates, where the spot market is being bought
and metal is then being leased for various
lengths of time to help offset carrying
costs.
Meanwhile,
what may be happening in the futures markets
is that speculators are net sellers of futures contracts against their physical
silver holdings, which, combined with weak demand
for futures in general at higher prices is probably
keeping a lid on futures prices and creating
backwardation.
Basis
risk is the risk that prices in the futures
market will not follow the spot market up
or down for a variety of reasons but usually due
to widespread fear of an imminent default,
closure or major rule change of the futures
exchange. Basis risk is not very
relevant for most small speculators who
hold simple positions which are not hedged
or offset, but
it is a key consideration for many sophisticated
market players as explained by Antal Fekete
in the thought-provoking Bull
in Bear's Skin? and Ultracrepidarian
Musings. Mr. Fekete makes a very good
point that basis risk is bound or limited
on the upside (basis will never substantially
exceed the carrying cost of a commodity;
see below for why) but is unbound and unlimited
on the
downside (where risk is theoretically unlimited
since a delivery default literally means
no supply is available in the spot market
at any price). This is the exact opposite
of price risk, where the downside risk is limited
(prices cannot go lower than zero) while
the upside is unlimited (prices can theoretically
rise to infinity).
To
be more precise, only a long position in
the futures market creates infinite basis
risk and then only in case of a contract
delivery default. To see why, assume the
long position is held for delivery of metal
to be used to repay a private metal lease.
When delivery on the futures contract is
not available, the short metal lease position
essentially becomes unhedged and price risk
takes over, which as we all know is infinite
in case of a short position. It may do a
person no good to be a creditor of
an infinite amount to one party while a
debtor of an infinite amount to another
party, unless all sides are prepared and
able to make good on their infinite debts.
In
contrast, a short position in a futures
contract will be absolved of infinite
debts because the futures exchange will
need to arrange intra-exchange settlements
at some fixed monetary amount.
In
the case of monetary metals like gold and
silver, unlike other commodities, Mr. Fekete
claims that basis risk is especially acute
due to gold and silver's unique monetary
status because new supply cannot
be counted on to eventually bail out shorts who
need metal for delivery. This is the case
since drastic monetary conditions are expected
to result in gold and
silver taking over the role of money and these
monetary metals at some point will not be traded away for any future promise,
especially fiat currency, regardless of
how tempting. Another way to say this is
if/when gold and silver become the
only form of payment accepted for goods
and services, gold and silver futures
will be DOA since prices will no longer
be denominated in some external currency
but rather in gold or silver itself! As
a result, metal required for delivery
against a futures contract will only be
attainable by providers of valuable
goods and services (which presumably excludes
the financial intermediaries who maintain
most of the short positions in gold and
silver).
There
is one problem that I can see with this argument
-- not with respect to validity but rather
outcome. If, as Mr. Fekete claims and as
I also suspect to be at least partially
the case, shorts in the futures market are primarily spreading
their long exposure or deriving income from
metal physically held in their own possession, there would in
fact be enough gold and silver ultimately
available for delivery even as spot prices
approach infinity and the basis collapses.
In such a case, the futures exchanges
would become an efficient means to
transfer staggering amounts of wealth from
shorts to longs. That is, if default can
be avoided. And of course since the "bull
in bear's skin" shorts don't really
want to give up their gold and silver, it
is unclear whether it might not be better
for them to let the futures exchanges go
ahead and default. Later, they could
always use the legal system and their political
power to keep as much physical gold
and silver as possible (in any case
more than they are entitled to). On the
other hand, there is the likelihood that
the futures exchanges would simply go
into liquidation-only mode at the slightest
whiff of impending default. That is, the
small guy will probably get screwed
while the big fish get to have it both ways.
Sound familiar? If not, visit some of my
musings on the gold and silver ETFs.
Okay,
enough idle speculation, let's get back
to our discussion of basis.
I
have informally been tracking the basis
in gold and silver for the last few years
but with current market developments such
as the launch of gold and silver ETFs and
the amount of fund money flowing into these
markets, there is a possibility that sustained
and significant changes in the basis may
foretell impending and drastic changes in
the market. So I have decided to start analyzing
in detail
the basis for silver.
While
the basis in corn or wheat is simply the
difference between the local market price
and the equivalent price on the futures
exchange, the basis in monetary metals is
a little more complicated. While a warehouse
operator might work the current harvest
or the next several crops, each of which
will have its own basis, there is really
only one basis we care about in the monetary
metals. This is because the spot markets
are dominated by New York and London and
the futures markets by the COMEX in given
contract months.
Let's
see how the basis might operate in the case
of silver to see which measure of basis
is critical. Suppose in June 2006 I
acquire 5,000 ounces of silver in 1,000
oz. COMEX eligible bars at $10 per ounce,
which at the time represents a 20 cents
buyer's premium to the New York spot price.
If I decide to have my silver professionally
stored, I will immediately start incurring
storage fees of 1% to 1.5% per annum based
on the value of the stored silver. Let's
say this is what I opt to do. But let's
also say I don't like to pay storage fees
and instead I'd like to see my silver generate
income, encouraged as I am by Mr. Fekete's
essays.
So
I decide to look out one year and notice
that the July 2007 futures contract (the
closest to one year from May 2006) carries
a premium of 1% to 1.5% over the spot price
(excluding the 20 cent markup that I paid).
No good, I say to myself, since in one year
I'll have paid the equivalent amount in
storage fees. As I go closer or further
out in time, I also notice a corresponding
change in the futures price such that I
cannot generate enough advantage to offset
my storage costs. Disappointed, I conclude
that the basis seems to offer me very little
advantage as the market seems to be priced
efficiently after all.
But
then I notice something -- just as Mr. Fekete
says -- there are call options out there
with active bids (buyer interest) seemingly
far enough out of the money that silver
prices are very unlikely to save them from
expiring worthless. Yet speculators seem
to want these options in large quantities.
In fact, I can write a call option for $500
that carries a strike price of $11 and expires
in 30 days or less, which is sufficiently
out of the money that I can sleep at night.
$500 happens to be 1% of the $50,000 I paid
for my 5,000 oz. of silver. If all goas
as planned, the call option I wrote will
expire worthless and I get to keep the $500
premium as "income" on my 5,000
oz. of silver. And I can do this again and
again throughout the year. The worst thing
that will happen is that the price of silver
will exceed the strike price of the call
option, at which point I will either buy
back the call option or allow it to be exercised,
closed out or held for delivery. If the
strike price is achieved, I will essentially
have made 10% selling my 5,000 ounces of
silver and I can immediately buy it back
again to repeat the process. So. let's see,
I make anywhere between 1% and 11% in 30
days (an annualized rate of 12% to 121%).
If I make only the annualized 12%, the consolation
prize is that I get to keep my silver. If
I make more because I buy back the call
option or it gets exercised against me,
I lose my silver but I make up to 121% on
an annualized basis and I can always buy
more silver and do it all over again. And
I can do the same thing with gold.
Who
says silver and gold generate no income?!?
Okay,
not so fast. There are other considerations
such as the margin requirement that must
be maintained on written call options plus there
is undoubtedly going to be some slippage
as trades are executed. On the other hand,
this is something that can be done every
month but one. Even though only the so-called
"contract months" in silver and
gold have enough trading volume and open
interest to ensure liquidity and efficient
pricing, the months do not overlap with
the exception of December and only November
is not a contract month. In silver, the
contract months are January, March,
May, July, September and December. In gold,
they are February, April, June, August,
October and December. So the returns I calculated
above might in fact be close to achievable
for an astute trader with a good broker
or direct access to the trading floor.
Besides
being interesting, how does all of this
relate to basis? Let me tell you. Writing
call options is actually only one part of
the trading strategy of many commodity pool
operators, market makers and other futures
market participants. These activities tend
to be interwoven such that futures and options
prices tend to influence one another as
the sophisticated market participants take
advantage of mispricing. As an example of
this, if put options were being bid well
above fair value by speculators, the market
specialists would scramble to write those
expensive put options and hedge with a combination
of futures and call options. They would
lock in a guaranteed profit regardless of
what happens with prices. Such opportunities
do not last long in the futures markets
and certainly the average trader is not
adroit enough to take advantage of them.
Having
established that it is possible to earn
an income from writing call options expiring
in 30 days or less against physical holdings
of gold or silver, it stands to reason that
a portion of call writing is being done
for this purpose. Should this call writing
slow down or cease for one reason or another,
the reverberations to futures prices would
be measurable. This is because premiums
on call options would start to rise until
market specialists looking to initiate short
positions would be attracted to doing so
via writing call options instead of short
futures positions. This in turn would create
ripple effects in many trading programs,
the net result being that the basis would
initially rise.
Why
rise instead of fall as Mr. Fekete predicts?
Well, I did say initially. The rise would
be due to less short interest since a significant
seller (the writer of call options looking
for income) would have exited the futures
market. I believe it would take some time
for the realization to set in with other
market participants as to why the call option
writers are no longer in the game. And as
Mr. Fekete states, a prime reason might
be the presence of consistent gains
in their physical gold and silver holdings
making it too risky to attempt generating
income through call writing. Here's why.
Remember that I said earlier that it would
be no big deal if a written call option
went into the money since the gold or silver
could be replaced? Well, what if prices
were so volative or supply so uncertain
that this statement were no longer true?
In that case, the risk of losing the physical
position and not being able to replace it
outweighs the lost income that could be
generated.
When
this point is reached and more and more
market participants start to realize it,
futures demand (long interest) could start
to evaporate while supply (short interest)
could grow precisely at the same time that
the opposite is happening in the cash market.
Another way to say this is that paper would
be spurned for the real thing and futures
prices could actually fall or more likely
fail to keep pace with the exploding cash
price of silver and gold.
If
all goes according to theory, the basis
will predict these events. More specifically,
the basis represented by the spread between
the cash price of gold and silver and the
futures price in the nearest contract month
is what will sound the alarm. This basis
can be measured in absolute terms or more
usefully as a relative basis which is measured
in terms of days to option expiration where
a 10 cent absolute basis with 5 days to
option expiration equals a 2 cent relative
basis.
At
least that is the theory. It sounds pretty
solid to me and that is why I started to
look closer at the basis and to track it
daily on the website. Soon I will also carry
charts tracking the basis historically as
well as provide further analysis.
In
the meantime, remember that the likely sequence
of events before a plunging basis is a steep,
temporary rise in basis. Also remember that
the basis will not plunge without all sorts
of other signs throughout the global economy
that the public (or at least the wealthy)
is losing faith in paper-denominated
assets. Remember too that in silver the
basis is measured as the difference between
the cash price and the futures price of
the nearest contract month with active options.
For example, In June 2006 the basis would
use the July 2006 contract but come
July it would become the September 2006
contract. Therefore, we will consider the
silver basis "dead" when call
options in the nearest contract month are
more than 30 days from expiration. When
the silver basis is "dead", the
gold basis is "alive" and vice
versa except for the month of November when
both the silver ang gold basis are "alive".
Lastly,
let's note that the current reduced basis in silver
futures is probably an anomaly and
not necessarily related to the imminent
delivery default which Mr. Fekete warns
about. For delivery defaults to be a near-term
possibilty, the basis would have to fall
consistently across all time frames in the
same manner that lease rates would need
to rise in unison.
The
interesting thing about the basis is that
it is not an all or nothing proposition
-- it should hold true in market gyrations
of lower amplitude and thus I intend to
incorporate it into my overall analysis
of the silver market regardless of how far
away we might be from financial Armageddon.
In
closing, I would like to thank Mr. Fekete
for his invitation to start thinking more
about the basis because although it is not
currently telling a tale of a silver market
about to be cornered, it could very well
do so at some point in the future. Therefore,
effective immediately, I will take up his
challenge and start displaying
and periodically analyzing what the
basis has to say about the silver market.
I presume others will follow including those
who prefer to focus on gold (which is currently
showing a very robust contango, by
the way).
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