-- Posted 11 June, 2008 | Digg This Article | Discuss This Article - Comments: 8

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A Primer on the Silver Basis

Gold Standard University

aefekete@hotmail.com

I started writing this piece as the sub-prime crisis was unfolding. I wanted to establish the connection between the silver basis and the budding banking crisis caused by phony bond insurance schemes and the lack of hedging irredeemable dollar debt with metal holdings. My original title was Putting Clothes on the Naked Bogeyman. As writing progressed I realized that it would take more than one article to dress up the bogeyman; hence the revised title.

Trading hedged corn

When I tell my audience at Gold Standard University Live that huge quantities of commodities are bought and sold every day without any reference to the price, my words are received with an incredulous silence. It appears incredible to the uninitiated that the price risk can be neatly side-stepped. I have to explain to my listeners that when the professional grain trader gives an order to buy or sell corn, he may be unaware whether the price of corn is up or down. He doesn’t care. He is buying and selling hedged corn, and he takes his clues from the basis, not the price of corn itself. He has replaced price risk with basis risk which he knows how to handle as its behavior is less erratic and more predictable. Most people don’t realize that the bulk of grain trading on the futures markets is driven not by the price but by the basis.

In the grain market by basis is meant the difference between the futures price and the local cash price of the grain. Thus the basis varies from place to place, and from one delivery month to another. Trading the basis means buying or selling hedged grain. The merchant goes long on the basis by purchasing hedged grain when the basis is wide, and selling it when the basis is narrow (possibly negative). He goes short on the basis by selling hedged grain first when the basis is narrow (possibly negative), and selling it later when the basis is wide.

The myth of naked shorts

The silver market is similar. Large quantities of silver are bought and sold every day without reference to the price. Professionals trade hedged silver on clues from the silver basis. They are not gambling on the price variation of silver: they want to earn a reliable income on physical silver already in store. They may do this on their own account or, more typically, on customer account. The ever growing inordinate and concentrated naked short position in the face of a strongly rising price is a myth.

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