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Silver Likely to Drop to Around $31 an Ounce: Charts

Tuesday, 10 May 2011 | 7:48 PM ET

Six weeks ago US Federal Reserve Chairman, Ben Bernanke, put markets on notice that changes were coming. It was a gentle hint to reform their own houses, or have reforms been forced upon them. When speaking in Georgia, Bernanke chose to address the topic of clearing. It was an early warning that changes were coming. The most obvious of these would be adjustments to the level of margins.

In my comments to CNBC immediately after Bernanke's live speech I highlighted the potential consequences for commodity markets. The last week has borne these out.

Officials from the CME group were worried about the bubble in silver pricing. They increased the margin rates. A report in the New York Times claims “they did not realize it, but they were about to take the first step towards popping the bubble in global commodity prices.” This is a disingenuous claim.

The last great bull run in silver when the Hunt brothers tried to corner the market was halted in the same way. The 1980 speculative bubble in silver collapsed when COMEXchanged the future contract margin requirements from 10 percent to as high as 100 percent. Traders had to come up with more money to finance each current and new trade and this caused the market to collapse.

There is no conspiracy to lift the margin requirement for silver. The clearing houses have a commercial and business agenda. They must be confident that their clients can fund the increasingly expensive positions. Increasing the margin is prudent business practice.

However, some traders are asking if this is not also similar to market manipulation where prices are impacted by the activity of participants to achieve a desired effect. They argue that a gradual increase in margin is fair and reasonable, but the multiple increases in margin requirements in the last seven days smacks of a more active intervention in the market in a way designed to impact prices.

The last week saw multiple rises in the margin required for silver trades. Traders with open positions had to come up with increasing amounts of cash to keep the position open. These margin calls made it more difficult for traders to fund their positions. Many had little option but to sell, and their selling cascaded through the silver market crashing prices to below $36/ounce.

The parabolic trend pattern that developed in silver confirmed the development of a speculative market. It also indicated a sudden and dramatic price collapse at the end of the parabolic trend. And just as with the parabolic trend in oil in 2007, the collapse of the trend was triggered by an event external to the fundamentals of the market. Regulatory risk where the mechanics of the trade are changed is again confirmed as a significant new risk factor in trading.

The collapse in the silver price from $49 to below $36 is a harbinger of collapses in a wider range of commodity prices. It is the end of speculative bubbles that have been building for several months. The collapse is triggered by changes to the way the trade is executed. This is regulatory risk in action.

The fear of contagion spreads to other commodity markets. How long would it be before margins were lifted in other hot commodities like gold, oil and copper?

An important price threat comes from the Exchange Traded Commodity Funds. (ETCF) Their trading activity is dictated by the demands of their investors. It is not driven by demand and supply of the commodity.

When their investors have confidence in the commodity price they buy more of the ETCF which in turn forces the fund to buy more in the commodity market. This buying helps support prices and to continue the uptrend pressure. When these ETCF investors decide it’s too dangerous in the commodity market they send sell orders to the ETCF. The ETCF must sell to meet investor redemptions.

Funds, who should know the market structures better than most, have been reduced to sending letters to investors claiming they are “at a loss to explain what has caused the crude oil market to be annihilated.”

Again this is disingenuous. The parabolic trend clearly indicated a dramatic collapse in the silver market. The cause of the collapse was unknown at the time the trend was first identified, but Bernanke s’ comments soon pointed the way.

The potential result of a parabolic trend collapse is best seen in the oil price chart following the 2007 collapse. More recently it is seen in the collapse of the parabolic trend in the dollar Index chart in 2009. Look for downside in silver to around $31. More importantly, look for extreme downside targets in other commodities where speculative investment activity via ETCF’s was high.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.comand producer of Gold – Mining the Markets. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.

CNBC assumes no responsibility for any losses, damages or liability whatsoever suffered or incurred by any person, resulting from or attributable to the use of the information published on this site. User is using this information at his/her sole risk.

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