Investing

Let me detour for a moment to explain this keystone to understanding the present silver market. What is "delta hedging"? When option holders see prices move a certain amount away from the strike price of options they hold, option theory demands that they buy or sell an offsetting amount to cover their increased risk. This "delta hedging" is that increased selling or buying, i.e., the option holder must hedge the delta ("change") in his position. For instance, if you are long by virtue of holding call options, accepted option theory prescribes that you sell so-and-so much more silver as the option rises further above the strike price, in order to maintain the same level of risk in your position. Conversely, if you are short through options you have to buy more as the price drops further from the strike price.

Intuitively this doesn’t make much sense until you realise what the option seller aims to maintain. Merchants of physical commodities never try to make a profit on the rise or fall of the market, but rather only from the transactions they perform. Therefore they manage their positions (inventory) so that they never grow or shrink. How do they do this? By adjusting their bid and ask prices. With the silver market at $5.00 an ounce, a physical merchant might be buying silver for $4.90 an ounce and simultaneously selling for $5.10 an ounce. If he owns an inventory of 10,000 ounces of silver, he will raise his buying and selling prices as he sells inventory, and lower his buying and selling prices as he buys inventory. This tends to keep his inventory stable ("flat"), and a flat position carries no risk. (Ignore the 10,000 that he owns. He doesn’t care what happens to the value of that inventory. He only wants to use it for making transactions. He’s not an investor, he’s a merchant, and he makes his living buying and selling that inventory, not on the rise or fall of the market.

Options merchants or sellers ("bullion banks" and "producers"), on the other hand show much different behaviour. Why? Because their leverage in their inventory is not one to one, but varies with the relation of the option strike price to the market price. As they lose, their leverage gears up the loss to increase at an increasing rate. As they gain, their leverage gears the loss to reduce risk. Their exposure remains relatively stable over a certain range of market prices, but violently increases outside that range.

Options sellers operate just like bookies. They know that most bets run against the bettor; the house usually wins. However, once in a while a long shot comes in and the house loses big money. Just like the house in a casino, the options seller he faces a risk curve where most of the time he collects free money (just back up the truck). What’s the downside? Outside a certain range, he faces terrifying, potentially annihilating risk.

Without resorting to any conspiracy theory, the last 20 years’ rise in options activity alone could explain why both gold and silver stagnate in a narrow price range with periodic violent moves outside that range. Increased options activity virtually guarantees that any market will act that way.

Why? Because the options merchants is not hedging an inventory so much as a level of risk. If you sell one call option at-the-money (same price where the market currently stands), it has a "delta" or risk of change of .5 or 50%. That is, there is a 50% chance the price will go up, and a 50% chance the price will drop. The further the price moves away from the option strike price in such direction that the seller loses, the faster the "delta" or risk rises. In order to maintain the same "delta," the option seller must buy more and more silver.

Suppose the market stands at $5.00, and you sell a call option for 5,000 ounces of silver with a strike price of $5.00. Your delta is now .5 or 50%. If the market drops to $4.50, the option moves farther out-of-the-money and the delta drops along a curve (not in one-to-one ratio). Say now the delta is .25 or 25%. Now you are short only the equivalent of 2,500 ounces of silver. To maintain the same delta you started with, you have to sell more options. As options activity increases, this will put more and more pressure on the market.

Now suppose the market goes the other way. It stands at $5.00, and you sell a call option with a strike of $5.00, i.e., at the money. You are now short the equivalent of 5,000 ounces. Suppose the delta is .75 for the 5.50 strikes, and 1.00 for the 6.00 strikes. The risk increases on a curve up at an increasing rate. Now when the price reaches $6.00, you are short the equivalent of 10,000 ounces, or twice as much as you intended. You have to somehow buy the equivalent of 5,000 ounces to restore your position to its original .5 delta.

What does this imply? That increased options activity (such as the Derivatives Revolution of the past 20 years) will (1) moderate prices (decrease volatility) over a certain range but (2) violently exaggerate price moves (increase volatility) outside that range.

What else does it hint? That futures merchants and hedgers ("bullion banks" and "producers"), once they establish an options position, have a colossal self-interest to protect. That self-interest is wholly wrapped up in the market price remaining in a certain range. That self-interest will be french-fried and incinerated if the price escapes that range. If one were a prosecuting attorney looking for a perpetrator, that would certainly give merchants and hedgers a motive to manipulate the market. Even if they weren’t operating in active, conscious concert, their behavior -- driven as it is by the logic of their position -- would make their actions look like a conspiracy.

-- F. Sanders

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