Is now the time to buy into silver?

I’ve never hidden the fact that I’m a long-term commodities bull. So it came as quite a surprise to many readers when I recently showed a bit of hesitation over the silver market.

Last time I said that I’m wary on silver. I said it was too volatile for my liking – that investing in silver is like a dance with the devil.

In the days that followed, I received a torrent of messages from irate silver investors. Several of them pointed out that I only skated over the topic. That I hadn’t explained why the silver market is such a volatile beast.

And they are right!

So today I’d like to set the record straight. In the week when silver suffered a savage correction, I’d like to pick apart exactly why it’s so jumpy. And whether now is the time to buy in to the precious metal.

Three reasons why silver is such a beast

There is a lot to like about silver. And I own some myself. I hold physical silver and a silver ETF.

But things went awry for silver last week:

Spot silver during 2011

Silver price

Source: IG Index

And after such a savage fall, you may think that silver is beginning to look a bit tempting. The long term bull case for silver is certainly compelling – especially if central bankers continue to debase currency.

So why am I still wary on silver? And what explains the sudden crash that we have seen over the last week?

Well I see three reasons for its volatility.

First, commodities markets attract speculators. Most of the players never expect to take delivery of the underlying commodity – they just speculate on price movements. These traders use massive leverage to beef up returns. But when the trade moves against them, they’ve got a problem.

As the price of silver approached the key $50 level, many silver traders will have placed orders to sell their holdings. That’s probably why silver retreated from $50 to $45 so quickly. The dollar retracement on the back of Bin Laden wasn’t the key factor here.

And in this market, it doesn’t take much profit taking for a correction to turn into a rout.

As their positions hit negative equity, traders need to pay their counter party to balance the books – it’s known as a ‘margin call.’

How do traders finance margin calls? Well often, they have to sell down winning positions to raise the funds. Remember, these boys could have hundreds of different positions in silver. They’ll be selling the ones ‘in the money’ to finance the ones under water.

So as silver goes down, the traders sell even more silver to finance margin calls… very quickly the thing turns into a rout. The leverage leads to massive price swings.

The second reason why volatility is so great in silver is because of the size of the market. In comparison with global markets for bonds and equities, bullion markets are tiny. Bullion represents under 1% of the financial markets.

Over the last few months rumours that large funds were moving into precious metals caused a price surge. And nowhere more so than silver. In dollar terms, the market is much smaller than gold – and yet in recent weeks silver volumes have been reaching the same level as gold. That was clearly unsustainable for such a small market.

But as well as speculation and the size of the market, there’s a third and less understood reason for silver’s unhealthy volatility…

Who really understands this market?

The problem with silver is that it’s hard to find decent analysis on it. It’s a very secretive market driven by a few ‘in the know’. These are the miners (who sell the stuff), the speculators and the industrial end users. And they don’t give out much information on which way they’re trading.

That’s the biggest problem with silver – very few people understand what’s actually going on in the market.

The upshot is that many private investors take to the internet in search of what they need to know about silver. A few internet sources have attracted armies of followers. And from what I can see, all these guys are bullish…

But where’s the balance? Who’s making the bear case argument?

The type of cult following for internet campaigns like the ‘Silver liberation army’ is a sign of information asymmetry. Just a couple of ‘analytical’ sources doling out a very slanted view on the market.

I don’t mean that people shouldn’t read some of the stuff available – it’s often interesting and fun. But making investment decisions on prejudiced information is not a good idea.

The point is that this imbalance in the silver market leads to serious volatility. A highly secretive market coupled with a couple of highly focused web campaigns ‘exposing’ the silver market has lead to more than a few investors getting their fingers burnt.

Don’t dance with the devil

Okay, so the silver market is volatile. And playing it with leverage is risky. So what do you do?

Well there are ways to get around the volatility of silver. Take mining stocks – these are a completely different beast to trading silver on exchange.

For a start, leverage is much less of an issue. Stock traders don’t use the same sort of trading tactics and leverage as in the commodities markets. And unlike the silver bullion market, stock trading is much more transparent. If your stock is listed on an exchange there are all sorts of rules for insiders to follow. That simply isn’t the case for the bullion markets – much of which trade over-the-counter in an unregulated environment.

If you buy a mining stock, you can look at the company accounts. You can estimate the silver reserves the company is sitting on. Trawl through the annual production figures and costs of extraction and you can start to understand the profitability of the enterprise.

The problem is that there are’t many pure silver plays on the market. And several of these silver miners have gone on a tear in the last year. Arian Silver for example, is up over 310% in the last year alone.

Now I’ll be keeping a close eye on these silver miners in the wake of this correction. It could be that there are some interesting prospects if they come down – and silver gets back on track (as I believe it will).

But I have to say that I think gold is still a far better investment. Gold is the currency of the central banks who have turned from sellers to buyers. Gold is a deeper market, less subject to manipulation and the whim of media campaigns.

Frankly, gold is a market that’s much easier to read. And that’s what I want in an investment. Something I understand and whose price movement has a sense of trend. Sure, silver is in an uptrend, but you need a strong constitution to cope with its lurches down.

Two weeks ago I said that I think it is wise to hold 5% to 10% of your wealth in gold. And for a traditional investor, I think your best option is an ETF (LSE: PHAU).

In the meantime, I will keep an eye on those silver miners. And if any silver bulls know a way to get around the volatility in this market, I’d be delighted to hear it – you can leave a comment below.

Good investing.

• This article was first published in the free investment email The Right side. Sign up to The Right Side here.

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