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For Silver, A Keltner Warning

12/22/10 09:30:36 AM
by Donald W. Pendergast, Jr.

Imagine: less than eight years ago, you could have bought silver at less than $5 an ounce. These days, silver is not only priced six times higher, it may also be giving advance warning of an impending reversal -- this time on its monthly chart.

Security:   YIG11, SIG11, SLV
Position:   N/A

I remember reading most of investor Ted Butler's articles regarding what he viewed as a major silver buying opportunity during 2001-2008 period and was amazed at how insightful his fundamental understanding of the silver market actually was. Nearly 10 years ago, he predicted silver would multiply in price, and sure enough, he was right.

Fundamental analysis (silver supply/demand, seasonal and related mining company financial trends) is vital to the success of long-term silver holders (and short sellers too!), but so are the technical charts for every thoughtful silver trader/investor, and right now, the message that the monthly chart of silver futures (Figure 1) is flashing to wise traders is this -- the market is getting close to an overextended/reversal point, just as it has done on three separate occasions since 2004. Here's a closer look at the technicals, followed by an idea on how to play a potential reversal without getting your head handed to you, in case silver decides to keep moving higher.

FIGURE 1: SILVER, MONTHLY. Selling far out-of-the-money, near-term silver futures call options at points 1, 2, and 3 would have been a very profitable activity. Might not the current setup at point 4 also yield substantial gains to savvy silver call sellers?
Graphic provided by: MetaStock.
Graphic provided by: WB Detrend RT EOD from ProfitTrader for MetaStock.
The two pairs of Keltner channels are constructed by running a 45-month exponential moving average (EMA) and then plotting the bands at 4.235 and 7.5 average true ranges (ATRs) away from that average. This pair of channel settings work very well together on a variety of time frames and are terrific for those who like to trade futures options when the underlying commodity is at a statistically significant peak (valley) beyond which further price gains (losses) become much less likely. For example, note on this long-term monthly silver chart that the price of silver rarely spends much time above the extreme upper Keltner channel, and even after an excursion beyond it, it typically corrects back down to the next lower channel line (blue line).

If you look at point 4 on the chart, you'll see that the silver futures market is on the verge of completing a monthly close above the upper channel line, so we know at least that we are getting very close to a resistance area that has historically turned back price, time after time.

Glancing at the bottom of the chart, we also find that the ER indicator (easily created in my MetaStock software; it simply measures the percentage difference between the 10- and 50-period exponential moving averages) is also confirming noticeable negative price-momentum divergence. Further down, you'll also see that the WB detrend oscillator is also flat to bearish, essentially agreeing with the ER indicator that the upward momentum is beginning to stall -- right near a statistically powerful resistance area, as previously mentioned. Unless silver is preparing to go vertical soon, this isn't the wisest place to be adding to long-term silver holdings, not by a long shot.

Here's a better way to play silver as this potential reversal setup develops.

March silver options (COMEX) expire in only nine weeks (February 23, 2011), so why not consider selling a far out-of-the-money silver futures option, say, a March $39 call for a premium of 0.1300 or better? That will put $650 cash directly into your margin account and will also give you plenty of leeway to ride out some further price gains in silver over the next month or so. It also relieves you of the needless stress of attempting to time the exact top in the silver market, and since you already know that there is an above-average chance that silver futures will turn lower in the next one to two months, that also should provide you with the confidence to put on the trade.

Of course, if silver just decides to start climbing a dollar or two every week (day?) as a parabolic blowoff develops, well, just buy back the option if it doubles in price. (Ouch! So what? You'll make it back on the next trade or two, so what's the big deal?)

The good news here is that the value of your short $39 call will collapse faster than a house of cards if silver reverses soon after you sell it and it falls quickly toward the next Keltner support near $26. You may decide to hold the short position until expiry (at that point, a low-risk proposition) or if you're the control freak type, you may choose to buy the option back for a fraction of what you originally sold it for.

Either way, this is a very sound trading strategy, one that more and more savvy traders are beginning to embrace. Talk to your broker before attempting to sell calls in the silver market and make sure you understand all of the risks as well as the potential for reward. It's a great way to trade the futures market, when approached with a well-thought-out plan of attack.

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
Jacksonville, FL 32217
Phone # for sales: 904-239-9564
E-mail address:

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Date: 12/28/10Rank: 2Comment: 

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