*POP*!

It has been a busy month, and except for my mechanical trades (an update on those is coming soon), I haven't found the time to wander around looking at areas of the market that I don't usually trade.  About a week ago, though, I realized that I had heard a lot of buzz around the office about silver.  A month ago almost none of our traders were interested in trading silver futures, and now suddenly I was hearing about it from several different directions.  Curious, I brought up a chart.

(Silver ETF through May 2, 2011)

This, ladies and gents, is a bubble.  Having lived through the economic aftermath, we all have heard of the Tech Bubble of 2000 and the Housing Bubble of 2008.  Smaller financial instruments like silver don't get capitalized names, dates, and a lot of mainstream attention, because they don't push the economy around.  But here's a couple more from recent memory: the Oil bubble of 2007-2008, and the Agricultural bubble of 2007.  In the charts below, I have helpfully included the bubble-popping aftermath for 20/20 hindsight, which I held back in the Silver graph again (for the impatient, there is a full chart near the bottom of this post).

(Nasdaq ETF Apr1999-Apr2000)

(Oil ETF Mar2007-Jul2008)

(Commodity ETF Jan2007-Mar2008)

Sadly I can't find an ETF that captures the housing bubble well, but here is an excellent chart from another blog (thanks to James Parsons).  I haven't verified the source data, but it looks more or less correct.  The volume isn't pictured; in the context of home prices, that would be the real estate sales activity.  I could go do a bunch of research, but I won't.  We all remember the "flipping" craze of 2006-2007, right?

Housing prices 1970-2010, nominal and inflation-adjusted

In all of the charts above, notice the accelerating prices near the end of the bubble, and the corresponding accelerating daily volume.  This represents the "final blow-off phase", where everyone just has to be involved in this instrument.  Retail amateur investors do not belong in a frothy market like the ones pictured above, but the siren song of water-fountain stories about how Bob from Accounting doubled his money last month is a powerful draw.

In 2000, I had been reaping the rewards of the Tech Revolution, as I saw it, by working as an independent consultant on the side, more than doubling my salary by charging consultant rates and putting in 20-30 extra hours a week.  I suddenly realized that a lot of people had been making a lot of money in the stock market for a long time, and I was determined not to miss out on any additional free money.  I started reading the Motley Fool and buying more or less any stock that made a new high, with no regard for earnings (there weren't any) or prices.  I came late to the party, like most investors did, but I was convinced this New Economy (remember that?) was one that would love me and my technical mind, cradling me in its hammock of cash.  So I bought Yahoo at $120.  When it fell to $100, I listened to the Buy&Holders telling me what a great new bargain it was offering me, and I bought more.  When it fell to $60, I bought more.  When it fell to $40, I made my last purchase while gritting my teeth.  I don't remember where I sold it, but it certainly wasn't higher than $15.

I learned a lot in the next 8 years.  In 2008, when stock valuations were ridiculously high, the housing market was quietly imploding, and credit was rapidly shrinking, I heard a sudden increase in questions from people not involved in finance about how to get involved in finance.  I had doctors, dentists, and engineers wanting to argue with me about where oil was going in the next 5 years.  I had people telling me that $1.5million wasn't that much to spend on a 4-bedroom house with no land, and besides, you could just sell it for $1.8 in a couple of months! Suddenly everyone was a speculator, and everyone was loving the party.  Meanwhile I was reading economic analysis by folks like the Head Economist at Merrill Lynch, who was pointing out how silly it all was.  Every week he bemoaned the rapidly accelerating speculative frenzy, and forecasted a recession with increasing certainty and severity.  Finally in the summer 2008, I think in August, I decided it was time to take a position.  I bought puts on SPY, a lot of them.  I made about 800% on that trade; no, that is not a typo.  The money I made in that trade did not make up for the money I lost in my stock-index retirement accounts, but it certainly helped.

So a week ago, when I suddenly woke up and realized that I was seeing the top of a bubble in silver, I bought puts in silver.  I didn't buy many, because I'm unfamiliar with the market and I don't want to extend myself too far into a clearly volatile situation when I don't know what fundamental forces might be driving it.  Well, it turns out to be speculative craziness.  The CME decided to increase the margin requirements on its silver futures contract (SI), because it was seeing bigger daily ranges and was concerned that too many small speculators would be unable to make margin, leading to a meltdown (irony?).  Silver immediately turned about 120 degrees and headed straight for the floor.  I bought my puts the day after that announcement, so I missed the first big down day.  But here's the full-year chart of silver I held back at the top of this post:

SLV through present day

Is that not the most perfect bubble chart you've ever seen???

Two days later, I had more than doubled my money on the puts.  I sold a little less than half of them for more than I paid for the full position.  Now that remaining part of the position is worth more than twice my original investment.  In just a week, I'm up over 350% overall.  I like to use options for short-term directional plays like this, because I get leverage and limited risk.  I bought options worth about 4x more than I would normally initially invest in anything, and I spent about 5% of that on premium.  That 5% of the notional value is my maximum loss; leveraged out, I'm risking 20% of a unit of capital on this play.  It carries a high risk of loss, since the option really can (and often does) go to zero, but the leverage carries with it a high reward potential. 

Disclaimer:  it's tough to make money buying options.  It usually only works out well when there is a sudden violent movement - in the right direction - of my underlying stock/ETF/etc.  The problem, though, is that the probability of a sudden violent movement is captured in the term "expected volatility", and that's one component in the price of the option.  Just as you would pay more for car insurance if you had a history of vehicular homicide, you'll pay more for a put option on a stock that has a history of portfolio homicide.  So buying options usually loses money, and the art is to control that money loss and not let the option price go to zero.  But when they make money, oh boy.  I can turn a 30% drop in silver into a 350% profit.  That makes up for a lot of lost option bets.

This is usually where someone (you know who you are, Dad) tells me that I'm "profiting off the misery of others".  I see it a different way.  Do we all remember how it was the Evil Speculators that caused the 2008 crash?  Well, it's those same Evil Speculators that drove the silver price up above all reason.  Keep in mind, the catalyst for bursting this bubble was the CME increasing its margin requirements.  Do you really think that increased margin requirements are going to stop a hedger from buying silver futures because he needs a few truckloads of silver in a few months?  Of course not.  Do you think it would seriously impair the normal healthy speculation activities of the professional trading firms that provide markets to the hedgers, thus facilitating the modern financial system, as is their Patriotic Duty?  Certainly not - most trading firms have millions, if not tens of millions, in their margin accounts.  The only people severely affected by increased margin requirements are small-size speculators with underfunded accounts:  those 1-lot and 2-lot traders that are in there driving up the volume and generating water-cooler war stories.  These guys are cruising along with $10,000 to $50,000 in a futures trading account, and they're sitting at their desks trading silver all day long when they should be doing something productive.  This is why the Chinese are winning, people.

Think of it as weeding.  Sometimes you have to kill off some buckthorn so the oaks can thrive.  Think of me as a chipper/shredder.