How Decoupling Works
jmski52
Posts: 22,869 ✭✭✭✭✭
Please excuse the length, but this is from Ann Barnhardt who was a cattles futures trader until she stepped away after MF Global made her realize that she couldn't protect her clients. Well done, Ann.
Originally penned and posted on December 15, AD 2011, seven weeks after MF Global.
3. Finally, a very simplistic explanation of how the cash commodity markets are soon going to decouple from the futures markets. This is a little complex, but stay with me. I think this is important to understand because none of us who have lived our whole lives in the U.S. have ever seen a market disintegrate.
The threat (or promise) of delivery upon expiration is what keeps the futures markets tethered to the cash markets. Up until now, if an unreasonably wide spread between the futures price and the underlying physical commodity market got too out of whack, a process called “arbitrage” would kick in. Arbitrage is when a party simultaneously buys and sells on two separate but related markets in order to capture an inefficient spread between those two markets.
I’m going to use precious metals as my example commodity because there are alot of metals guys reading this, and because the metals markets will be the big tell in term of when decoupling and thus total futures market disintegration is upon us. But these examples apply to all of the physical commodities.
Let’s say that the physical silver market is trading far lower than the silver futures price. This is what is called a WEAK BASIS. The BASIS is the relationship between the cash market and the futures market and is very simply defined as (CASH minus FUTURES). If cash silver can be bought at $25.00 per ounce and the futures are at $30.00 per ounce, the cash is $5.00 under the futures. When cash is under the futures, this is called a WEAK basis.
Up until now, what would a metals trader do? In very simple terms, he would buy the cash silver at $25.00 per ounce and then simultaneously sell the futures at $30.00. Because he has short-sold the futures, he could hold the contract to expiry and then deliver the $25.00 cash silver he bought to make good on the contract and receive his $30.00 price. So his simple net profit would be $5.00 per ounce. As many traders saw this spread and simultaneously executed this same strategy of buying the cash and selling the futures, what effect would this have? Right. It would cause the cash-futures spread to move back in toward convergence by pushing the futures price down (lots of sellers) and propping the cash market up (lots of buyers).
Now the opposite scenario: a STRONG basis. Let’s say cash silver is trading at $32.00 and the futures are trading at $28.00. A trader might take physical silver that he has in inventory and sell it in the cash market, and then immediately take those proceeds and buy back and equal number of ounces in the futures market and take delivery. Since the same number of ounces in the futures market cost $4.00 per ounce LESS, he would end up with the same number of ounces in his inventory PLUS $4.00 per ounce in CASH in his pocket. If he and many other traders saw this condition and they all sold cash silver and bought the futures, this would, again, converge the spread between the cash market and the futures market.
The lynchpin that is holding this dynamic together and keeping the futures markets tied to the underlying cash market is the fact that the futures contracts are deliverable, and a trader can either deliver or take delivery of actual physical silver via his futures position.
Are we seeing a problem yet? The futures markets have lost their viability and trustworthiness because of the MF collapse and theft. At some point in the not-too-distant future, people everywhere are going to realize that the delivery mechanism is not reliable. Heck, just holding cash and/or positions in a futures account is no longer reliable. The the market itself is not reliable, traders will no longer attempt to arbitrage these basis spreads because the risk to the trader that the rug will be pulled out from underneath them is simply too great.
And in the metals markets, the delivery process itself is . . . um . . . shall we say, easily corrupted? When you “take delivery” of physical metals, it doesn’t get sent to your house. All you get is a certificate saying that X number of ounces are being held in a certified vault somewhere with your name on them. After the MF collapse, that sounds like a joke, right? A CERTIFICATE with my NAME ON IT? Yeah. That really is how it works.
When the arbitrageurs finally lose all confidence in the markets, the cash market will decouple from the futures because no one will be willing to take the risk of having their money, positions and/or physical metals stolen/confiscated. If no arbitrageurs are willing to trade these spreads – no matter how wide they may become – and thus there is no force causing the cash and futures to converge, we will see the basis spreads become extremely wide. As people flee the futures markets, the futures prices will drop, while the cash markets hold steady or even diverge and actually rise as all of the former paper players realize that physicals are the only remaining game to be played.
Watch for this. Watch for the gold and silver futures to sell off as people walk away from paper while the online cash dealers, seeing that market demand for their physical inventory is robust, begin to ignore the futures prices and hold their prices steady or even raise them. When you see this basis decoupling and absence of arbitrage, lo, the end is nigh. A parabolic spike is coming.
linky
Originally penned and posted on December 15, AD 2011, seven weeks after MF Global.
3. Finally, a very simplistic explanation of how the cash commodity markets are soon going to decouple from the futures markets. This is a little complex, but stay with me. I think this is important to understand because none of us who have lived our whole lives in the U.S. have ever seen a market disintegrate.
The threat (or promise) of delivery upon expiration is what keeps the futures markets tethered to the cash markets. Up until now, if an unreasonably wide spread between the futures price and the underlying physical commodity market got too out of whack, a process called “arbitrage” would kick in. Arbitrage is when a party simultaneously buys and sells on two separate but related markets in order to capture an inefficient spread between those two markets.
I’m going to use precious metals as my example commodity because there are alot of metals guys reading this, and because the metals markets will be the big tell in term of when decoupling and thus total futures market disintegration is upon us. But these examples apply to all of the physical commodities.
Let’s say that the physical silver market is trading far lower than the silver futures price. This is what is called a WEAK BASIS. The BASIS is the relationship between the cash market and the futures market and is very simply defined as (CASH minus FUTURES). If cash silver can be bought at $25.00 per ounce and the futures are at $30.00 per ounce, the cash is $5.00 under the futures. When cash is under the futures, this is called a WEAK basis.
Up until now, what would a metals trader do? In very simple terms, he would buy the cash silver at $25.00 per ounce and then simultaneously sell the futures at $30.00. Because he has short-sold the futures, he could hold the contract to expiry and then deliver the $25.00 cash silver he bought to make good on the contract and receive his $30.00 price. So his simple net profit would be $5.00 per ounce. As many traders saw this spread and simultaneously executed this same strategy of buying the cash and selling the futures, what effect would this have? Right. It would cause the cash-futures spread to move back in toward convergence by pushing the futures price down (lots of sellers) and propping the cash market up (lots of buyers).
Now the opposite scenario: a STRONG basis. Let’s say cash silver is trading at $32.00 and the futures are trading at $28.00. A trader might take physical silver that he has in inventory and sell it in the cash market, and then immediately take those proceeds and buy back and equal number of ounces in the futures market and take delivery. Since the same number of ounces in the futures market cost $4.00 per ounce LESS, he would end up with the same number of ounces in his inventory PLUS $4.00 per ounce in CASH in his pocket. If he and many other traders saw this condition and they all sold cash silver and bought the futures, this would, again, converge the spread between the cash market and the futures market.
The lynchpin that is holding this dynamic together and keeping the futures markets tied to the underlying cash market is the fact that the futures contracts are deliverable, and a trader can either deliver or take delivery of actual physical silver via his futures position.
Are we seeing a problem yet? The futures markets have lost their viability and trustworthiness because of the MF collapse and theft. At some point in the not-too-distant future, people everywhere are going to realize that the delivery mechanism is not reliable. Heck, just holding cash and/or positions in a futures account is no longer reliable. The the market itself is not reliable, traders will no longer attempt to arbitrage these basis spreads because the risk to the trader that the rug will be pulled out from underneath them is simply too great.
And in the metals markets, the delivery process itself is . . . um . . . shall we say, easily corrupted? When you “take delivery” of physical metals, it doesn’t get sent to your house. All you get is a certificate saying that X number of ounces are being held in a certified vault somewhere with your name on them. After the MF collapse, that sounds like a joke, right? A CERTIFICATE with my NAME ON IT? Yeah. That really is how it works.
When the arbitrageurs finally lose all confidence in the markets, the cash market will decouple from the futures because no one will be willing to take the risk of having their money, positions and/or physical metals stolen/confiscated. If no arbitrageurs are willing to trade these spreads – no matter how wide they may become – and thus there is no force causing the cash and futures to converge, we will see the basis spreads become extremely wide. As people flee the futures markets, the futures prices will drop, while the cash markets hold steady or even diverge and actually rise as all of the former paper players realize that physicals are the only remaining game to be played.
Watch for this. Watch for the gold and silver futures to sell off as people walk away from paper while the online cash dealers, seeing that market demand for their physical inventory is robust, begin to ignore the futures prices and hold their prices steady or even raise them. When you see this basis decoupling and absence of arbitrage, lo, the end is nigh. A parabolic spike is coming.
linky
Q: Are You Printing Money? Bernanke: Not Literally
I knew it would happen.
I knew it would happen.
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Comments
Sure hope that's true. Would really appreicate just one more opportunity to sell it all at $1800 and $40.
fooled me once, shame on me
Liberty: Parent of Science & Industry
I'm with Jim Willie - this is a necessary event to breakdown the COMEX's power.
Natural forces of supply and demand are the best regulators on earth.
You may get your chance, Baley.
I knew it would happen.
Can someone please explain it all as if to a 5 yr old so maybe I can understand what is happening with PM?
I realize when a spread play vanishes a market collapses but I am not sure.
Seems some very smart people here think the PM market will go lower.
How much lower? Does anyone really feel comfortable with more than a guess or even worse an emotionally based guess?
Is the stock market next, short term?
I know, kinda like asking someone to explain if there a god, or what is dark matter or whatever.
Just looking for a simpler explaination.
Especially when I read other posts that talk about bands and waves and other conplex technical analysis jargon.
Thanks, I really appreciate these forums.
I was paying a lot of attention to her after MF global but I just couldn't handle her day to day weirdness .
While I respect everyones religous beliefs I just can't get through all of the complaining about the pope and how he doesn't run Mass correctly and all that gibberish.
Seriously , write a whole post about the pope so I can ignore it all in one spot and if you are going to burn the koran in a parking lot somewhere I'm not super interested in it. As the dragnet dude would say, " just the facts ma'am"
I prefer the fundamentalist approach, the technical approach leaves most of us "confused and feeling inadequate" as it does you.
What happens to gold:
The US bond market bubble pops?
When all the new money finds its way to the street?
When the FED looses control of its zero interest rate policy"
When no one but the FED will buy US debt?
The dollar is no longer recognized as the world trading currency?
Can the FED save the dollar and the economy? My answer to that is why I continue to stack, regardless of the price.
Natural forces of supply and demand are the best regulators on earth.
If you go into a shop and buy silver for cash, that's the cash price.
When you buy a futures contract for June, you are betting that you know which way the price will go when the contract expires in June.
In June, you can pay off the whole contract amount and take delivery if you want to. Or, you can cash out at any time before June and settle up for whatever the contract is worth when you sell it.
Here's the Key:
The threat (or promise) of delivery upon expiration is what keeps the futures markets tethered to the cash markets. Up until now, if an unreasonably wide spread between the futures price and the underlying physical commodity market got too out of whack, a process called “arbitrage” would kick in. Arbitrage is when a party simultaneously buys and sells on two separate but related markets in order to capture an inefficient spread between those two markets.
Normally, arbitrage is done by traders who see a disparity open up between one part of the market and another part of the market.
The point here is that - when the arbitrage process breaks down (for whatever reason), then the market breaks down and the mechanism for pricing and deliveries gets all screwed up. When that happens, nobody plays.
And when THAT happens, factories scramble around to find supply or they shut down.
I knew it would happen.
But I posted her commentary for its face value.
I knew it would happen.
<< <i>It does make sense that when there is no arbitrage happening, there will be no market other than in physical delivery. Enough people have been screwed on the Comex that this might actually be happening now.
You may get your chance, Baley. >>
Amen!! Great Post, jmski52!
30 days and the book will be written on this event.
I think the Euro is crumbling.
<< <i>Bronco, some of Ann's stuff is painful to read. The culture has painted her type to be nuts, when in fact she's devout. I find her perspective to be pretty scary and honest at the same time. I've watched the culture evolve, and I'm not a big fan of it either.
But I posted her commentary for its face value. >>
Yes and no. She is devout, and I'm a big fan of hers... but she is way over the top at times. Today she posted a graphic photo of man who lost his leg in the Boston explosion. There was no need to do that. It's disgusting. She's too convinced she's right about everything, even when she's wrong (like calling for a collapse by Dec 2011); and being too closed minded to change that's another flaw. But I digress.
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decline in the futures the much smaller physical market lags because
individuals are slow to adjust to the new price and are reluctant to sell at lower prices.
The futures holder of gold or silver contracts is a much different player. The margin
requirement on a gold contract worth $140,000 is only $5940. less than 5%. This
extreme leverage can exacerbate market movements. Shorts know this and they
take advantage of it. Same with major Investment Banks
like Goldman Sachs which started the decline last week.
I bought some Franklin half dollars yesterday. I can hold them forever if I want, at
$3 an oz or at $100. They may trade at a premium to melt now, but make no mistake
the futures determines 95% the price.
Now $7040 initial and $6400 maint.
Margin approximates 5% of contract value.
<< <i>
<< <i>Bronco, some of Ann's stuff is painful to read. The culture has painted her type to be nuts, when in fact she's devout. I find her perspective to be pretty scary and honest at the same time. I've watched the culture evolve, and I'm not a big fan of it either.
But I posted her commentary for its face value. >>
Yes and no. She is devout, and I'm a big fan of hers... but she is way over the top at times. Today she posted a graphic photo of man who lost his leg in the Boston explosion. There was no need to do that. It's disgusting. She's too convinced she's right about everything, even when she's wrong (like calling for a collapse by Dec 2011); and being too closed minded to change that's another flaw. But I digress. >>
A lot of the posts on different blogs are getting more polarized especially in the comments sections. I saw that same picture posted in the comments on the burning platform site.
I'm getting ready to flush jim quinn along with ann for being the opposite of devout. The outright racism thats starting to crop up over there is bothering me a lot lately.
I can read around a certain amount of garbage , people are of course entitled to their own opinions but when the signal to noise ratio gets past a certain point I can't deal with it.
It seems as though writing a blog leads some people to get too full of themselves and flame out . To me, thats Ann's problem. I'm looking for insight into the commodities market not a mentor to take me in hand and show me the true path to righteousness.
There was a post over at Jesse's about this the other day A plea for Civility
This is true, but if it were the whole story, volume in the physical market would dry up since few buyers would be willing to pay an unrealistic price to reluctant sellers.
Instead, we are hearing reports of huge numbers of buyers lined up at coin shops to pay the going rate. Also check out eBay, premiums of 25% to 30% on gold and silver bullion coins are commonplace.
Enthusiastic buyers of physical gold and silver, rather than reluctant sellers, are keeping prices elevated well above the spot price in the electronic marketplace. IMO.
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