Silver Trend Reversal Likely

12/09/10 09:04:05 AM

by Donald W. Pendergast, Jr.

Silver staged a stupendous rally between August 24 and December 7, 2010, rising nearly 67% during that time. Now, however, a pair of reliable technical tools suggest that the silver market may be heading into a corrective mode.

Security: SIZ10, SLV
Position: Sell

Attempting to call the exact top in a powerful bull market is about as wise as straddling the tracks, stopwatch in hand, certain that the bullet train is going to come to a complete halt instead of flattening you (and your stopwatch) because it took an extra 25 feet to come to a complete stop.

I'm sure that more than a few silver bears have had their respective heads handed to them over the past two months as the market refused to cooperate with their ironclad (pardon the mixed metaphor) mental scenarios that should have long ago (in their mind anyway) derailed this runaway metals market, once and for all.

The silver bears have some legitimate assertions:

1. An enormous amount of new silver supply is going to be dumped onto the world market over the next 18 to 24 months, according to some reports. Let's face it, it wasn't very profitable to mine silver when the market price was $4 to $5 an ounce (only about eight years ago) and there was no economic incentive at all to expand production. With silver staying well above $15 to $20 an ounce these days, however, now everybody wants to mine silver -- and when lots of big companies are doing so, you get tons more silver supply available. Then, when the price stops going up (due to faltering demand among silver speculators and slower industrial demand, for example), you've really got a problem on your hands -- demand is falling at the same time the supply is increasing. That's normally when the speculative commodity markets experience catastrophic blowoff tops, similar to the one in the silver and gold markets in 1980 and then again in the crude oil market in 2008.

FIGURE 1: SIZ10, DAILY. Silver futures might decide to go higher, but the technical and fundamental evidence strongly suggests otherwise. The reversal at point 2 speaks volumes about the near-term intentions of this particular market.

Graphic provided by: TradeStation.

In Figure 1, all we need to understand are two things:

1. The Keltner channel complex (set at 4.23 and 7.5 average true ranges away from a 45-period exponential moving average [EMA], respectively) has given traders and investors a very valuable bit of information: prices failed to meet or exceed the outer Keltner band on the last upthrust toward $31 and have now declined below the next lower Keltner band on two successive trading sessions on wide ranges. Yes, technically the uptrend is intact (higher swing highs and higher swing lows), but this Keltner clue easily trumps that reality. Silver traders and investors need to prepare for a likely drop toward the last swing low at $26.40, and if that quickly gives way, then they also need to expect that the Keltner midline (the 45-period EMA, currently at $25.85) will draw prices to this critical support line sooner rather than later.

2. The venerable COT net indexes (free with TradeStation and can be exceptionally useful in the hands of an experienced trader) plotted at the bottom of the chart also tell us a couple of important things. First, even though silver futures ran up to almost $30.70, the amount of hedge fund/large speculator net long positions was actually lower than it was when silver was trading at $24.95 on October 14, 2010, and also lower than when it was trading at $29.34 on November 9.

This is known as a negative divergence with the price action on the chart and is usually a reliable early warning of correction and/or trend reversal to come. As mentioned in an article I wrote about Priceline.com here at Traders.com Advantage, you normally have to give divergence setups plenty of time to play out, depending on the time frame you are trading; however, at some point the situation will be rectified by the price action itself. Many times I've found it wise to err in favor of the diverging indicator rather than hope for the price to start to revert back (in either direction) into major trend mode.

Playing this fairly low-risk divergence/Keltner confirmation setup might involve nothing more complicated than selling a far out-of-the-money silver futures option for a nice piece of change. Option premiums are at extremely high levels (as the situation has been bordering on near-mania among metal heads lately), and if this is a true reversal, selling a $40 March 2011 COMEX silver call option for about .2300 or better (about $1,150 in cash that goes straight into your margin account).

Check with your broker to see if this might be a suitable strategy for your account size and/or experience level, being sure to close out the trade if the price of the option doubles or otherwise gives strong confirmation that the uptrend is back in force. Trading futures options can be a very low-stress way to trade, especially if you truly get a handle on the various technical and fundamental/seasonal factors that drive the markets you wish to trade. Check it out: it's actually a lot of fun to trade in this unique niche of the futures market.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
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KELTNER CHANNELS

Silver Trend Reversal Likely

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