Regular readers, if there is such a thing, will know that I am not one for complex technical analyses. If you need a master’s degree in applied mathematics to see a chart signal, then it’s not a signal. I believe that technical indicators work because people are aware of them and trade based on their presence. The deeper you have to dig to find a significant pattern or level the less likely it is that anybody else will have seen it, and therefore the less reliable it will prove to be.
That doesn’t mean, however, that charts should not be used. Often a simple analysis of past price action will suggest a trade that has a good chance of success and limited downside; just the kind of thing we all love. If there are fundamental factors that support the trade then the only decision left is tactical; how best to exploit the opportunity.
Last week, when the CME announced that margin requirements for gold and silver had been cut, it prompted me to look once again at the chart for the iShares Silver Trust ETF (SLV) and just such an obvious opportunity jumped out at me.
The ETF, which reflects the price of silver futures contracts, looks to have formed a classic head and shoulders pattern on the 6 month chart. In fact, for connoisseurs of the obscure, it is even a “Batman ears” formation, as marked by the double spike on the “head.” This would usually indicate the likelihood of a sharp move down. In this case, however, there are complicating factors.
Firstly, let’s look at the news that originally prompted me to look at the chart; the CME has reduced margin requirements for silver contracts. This is significant. Silver, along with gold, has been going through an extended period of de-leveraging prompted by higher margin requirements imposed as an attempt to control that 2010 spike. Lower margin requirements should increase the amount of trading, and therefore the volatility of the market.
Secondly, we are close to two significant chart levels. The gold horizontal line on the chart represents the support at around $18.20. As you can see, this level has been tested and has held four times in the last six months, suggesting that it is a serious level. Extend the chart out further, to five years, and that approximate level looks even more significant, as the same level was a point of resistance back in 2010 before SLV spiked up to close to $50.
The grey, wavy line in Fig 1 is the 50 day moving average, and we are close to that also. This is one of those easily noticeable technical signals that I believe in. It is easy to see and therefore attracts interest.
A break through such a significant support level as $18.20 would probably cause a sharp move to the downside, while a break above the 50 day average, currently at around $18.87, would clear the way for a jump up. There are two ways of looking at this. SLV and silver prices in general, caught between upward and downward pressure, will continue to stagnate, or the opposite; something’s got to give! I prefer the second scenario, given the possible effects of margin easing.
So, both technical and fundamental factors would indicate that some volatility in coming months is likely. If you are familiar with options you will know that there is a fairly simple way to play this belief; a basic long straddle. In this case, July expiration calls and puts on SLV with an $18.50 strike price could (based on last traded price at Monday’s close) be bought for around $0.84 and $0.57 respectively. This would leave you looking for a move either above $19.91 or below $17.09 in the next two months in order to profit. The cost of the trade would be $1.41 per share, or $141 per contract, plus commissions. If SLV breaks either of the levels we are looking at, then neither $20 nor $17 looks that far away.
If you don’t trade options, then you could achieve a similar thing in a margin account. Just initiate a small position in SLV at these levels and then place two stop loss orders. The first would be to buy the same amount, doubling your position, on a break above $19.20. The second would be to sell three times the amount of the original position, leaving you short twice the original size, on a break below $18.
However you chose to play it, with the leverage that options trading affords or without, both changing market conditions and the proximity to significant technical levels suggest that a breakout is likely. By using, or replicating a straddle you don’t have to know, or even pretend to know, whether that move will be up or down; you are simply betting on a move.