Silver Extremely Overbought, Tops Analysis

Since emerging out of the usual summer doldrums, silver’s performance has been dazzling. Buyers are returning to this hyper-speculative metal en masse, driving some fast-and-furious gains. And the Fed poured rocket fuel on silver’s hot rally last week when it announced its newest inflationary campaign.

The broad commodities rally the Fed sparked helped catapult silver up a massive 11.4% in just 3 trading days! This amazing surge capped a total run of 58.3% in the several months since silver’s summer lows. It’s been a lot of fun watching some life return to this long-neglected metal, and we’ve enjoyed some big realized gains in silver stocks thanks to this silver upleg.

But no rally lasts forever, the markets flow and ebb regardless of how bullish or bearish their fundamentals happen to be. Has silver run too far too fast, propelling it into dangerous overbought territory? Is it topping? Many traders, including me, have been pondering these critical questions this week. The best near-term trading strategy for silver varies radically depending on the answers.

If silver has a high chance of correcting after such a blistering run, traders need to act accordingly. Before a correction it is essential to realize gains on existing positions, stop adding any new ones, and maybe even consider shorting or putting silver stocks. Optimally cash is maximized just before or soon into an emerging correction. On the other hand, if silver is likely to continue powering higher, the best strategies are exactly the opposite ones. So is silver topping or not?

Calling tops in real-time is notoriously hard. No mere mortal knows the future before it happens, and herd psychology can stretch mature trends well beyond rational endpoints. Nevertheless, prudent speculators still have to consider probabilities. Long-term success in the markets depends on only making high-probability-for-success bets. This maximizes winning trades while minimizing losses.

While we can’t see the future, the past is crystal-clear. So one way to game silver’s probabilities today is to consider its past major topping events in this secular bull. By looking at various technical conditions leading into those earlier toppings, and comparing them to today, we can gain excellent insights into where silver is most likely to head next. The closer today’s technicals match past major topping events’, the greater the odds we are indeed experiencing a new silver topping today.

This first chart looks at the vast majority of silver’s secular bull to define major toppings. Although this bull technically began in November 2001 at $4.02, silver really didn’t start rallying in earnest until October 2003 ($4.78). That’s when this bull’s first major upleg was born. As this chart shows, there haven’t been many major silver toppings, but the uplegs leading into them were very large and profitable.

Most traders new to silver fail to realize its fabled super-spikes are fairly rare. In 8 years we have only seen five massive silver uplegs. This sometimes-wild metal has spent the majority of its bull slumbering in long and boring consolidations. But when a big-enough gold rally finally awakens silver, traders flood into its tiny market so fast that its price can skyrocket. Hence this white metal’s seductive siren’s call.

The absolute price of silver is totally irrelevant from a trading perspective. Today $10 silver seems end-of-the-world low, I doubt any silver trader on Earth expects to see it again. But back in 2003 when silver averaged less than $5, that same $10 seemed impossibly optimistic. Naturally over time, baseline price levels gradually change. What really matters for trading this metal is how fast it got to its latest price level.

When silver falls too far too fast in a correction, it becomes oversold leading to fantastic buying opportunities. When it rallies too far too fast in an upleg, it becomes overbought which is a warning to close short-term longs dependent on it. But how can we measure this? Many years ago I developed a simple and powerful trading system called Relativity that empirically quantifies how fast any price has moved relative to its current baseline. You can learn all about it in my latest Relativity Trading essay.

In a nutshell, any price’s 200-day moving average forms a perfect baseline. 200dmas aren’t static, they gradually evolve over time to reflect new prevailing price levels. Yet they still strike a great balance by changing slowly enough to filter out the endless day-to-day volatility. And in a metal as wild as silver, there is sure no shortage of chaos to smooth! Relativity expresses silver relative to its 200dma, calculated simply by dividing silver’s daily close by its 200dma and charting this multiple over time.

The result, rendered above in light red, forms a well-defined horizontal trading range over silver’s entire secular bull. If you flattened silver’s black 200dma line to be horizontal, then recast silver’s price action in perfectly-comparable percentage terms relative to this flattened line, this is what you’d see. When silver falls too low relative to its 200dma baseline, it is oversold. When it stretches too high, it is overbought.

Based on this chart, I use a Relative Silver (rSilver) level of 0.96x as the oversold buying signal. When silver slumps to less than 96% of its 200dma, the odds heavily favor a new rally emerging. These are deeply-oversold major buying opportunities. The last one occurred in February 2010, when we indeed bought silver stocks near $15 silver and recommended our subscribers do the same.

Conversely, the top of the rSilver trading range is 1.40x. When silver stretches more than 40% above its 200dma, it is overbought and such stellar price levels aren’t sustainable. You can see in this chart just how rarely silver has exceeded this key metric. Before this past week, there have been only three other episodes in silver’s entire secular bull! And all three marked major toppings that signaled the ends of massive silver uplegs and heralded imminent sharp corrections.

So by its own bull-to-date standards, silver was wildly overbought this week! On Thursday the 4th in response to the Fed’s immense new debt-monetization campaign, rSilver surged to 1.396x which was the highest we’ve seen by far since March 2008 (a major top). On Friday the 5th and Monday the 8th, silver stretched even farther to 1.417x and 1.466x its 200dma. And intraday on Tuesday the 9th, before the raising of margins on silver futures spooked leveraged speculators into selling, rSilver was even more extreme.

Now realize overboughtness is a short-term sentiment thing, fundamentals can’t short-circuit it. I first recommended physical-silver investment to our subscribers at $4.20 in November 2001, and have earned fortunes for them trading silver stocks in the years since. After studying silver’s bullish fundamentals for a decade, I understand them well. Nevertheless, even in the strongest secular bulls prices get overbought from time to time and need to correct to rebalance sentiment.

And above 1.40x relative, silver is overbought. As this chart shows, it has simply rallied too far too fast to be sustainable. At this point I’d love to wrap up this essay and tell you the odds overwhelmingly favor an imminent sharp silver correction. But while Relativity analysis suggests this, other factors have muddied this topping signal considerably. Chief among them is the technical state of gold today.

Technically, silver is gold’s little lapdog. Silver only surges when gold is strong enough to get traders interested in precious metals. Silver always follows, and usually lags, gold. And if you do a similar rGold analysis to silver’s, the top of its relative range runs at 1.25x its 200dma. Despite gold hitting $1400 nominal for the first time in history this week, the most it has stretched over its own 200dma so far in today’s upleg is merely 1.168x.

So today gold is not overbought relative to this bull’s precedent! And if gold has farther to run yet, then silver is likely to continue catching a bid as well regardless of its own technicals. While silver corrections from overbought levels like today’s are brutally fast and large, its primary-driver gold almost always has to correct first to act as the catalyst to ignite a silver mass-exodus. Without a fairly-sharp gold retreat today, silver isn’t likely to plummet.

It is definitely odd seeing silver so overbought this early in a major gold upleg, when the yellow metal isn’t approaching overboughtness. I’m not sure why we’re seeing this anomalous silver outperformance, but I suspect it has to do with individual investors finally returning to the markets. Individuals dominate silver, and drive its wild swings. But thanks to 2008’s crazy stock panic, most individuals have been hiding on the sidelines in zero-yielding cash for the last couple years. As these ostrich investors gradually return, they are driving up volatility in sectors they frequent.

With rSilver arguing for a sharp correction, but gold opposing one, I wanted to dig deeper into silver toppings. So I looked at silver’s four previous major toppings in this bull, and compared their various metrics to today. This table quantifies some of the statistics I considered. The first three silver toppings are separated out as well, as the fourth was a very atypical post-panic recovery that didn’t carry silver to new bull highs like the earlier toppings.

The average gains in the primary uplegs leading to silver’s first three major toppings ran 92.0% over 7.0 months. Today’s rally is only up 58.3% over 3.4 months, so it still looks small and immature based on past precedent. But this rally has unfolded a lot faster. Its average daily gains of 0.81% dwarf the average of the original three uplegs of 0.62%. Does a smaller and shorter yet much faster upleg increase overboughtness and hence the risk of an imminent correction?

The next four columns highlight the gains in the final weeks leading into the major tops on the previous chart. The first three silver uplegs saw average final-6-week gains of 29.6%, while our current rally saw a similar 6-week run of 29.1% as of its latest high. The terminal 4-week average gain ran 19.9%, and today’s rally shot up 19.0% over this span. These comparable numbers also support the view that silver is indeed topping now.

More ominously, our current upleg’s gains over the last couple weeks before its latest top are much more extreme than precedent. Silver surged 17.3% in the 2 weeks before this week’s high, compared to an average of just 14.4% in the terminal stages of its first three major uplegs. And this rally’s final-week run of 12.4% is absurdly high, dwarfing the 7.3% average. By these metrics, silver looks much more overbought now than at terminal stages leading up to past major tops.

Interestingly though, on the way to those past tops silver spent more days above 1.4x its 200dma. We’ve only seen 2 days including Monday’s latest silver high, compared to 5, 29, and 4 historically. And that outlying 29-day episode in spring 2006 is particularly interesting. That was the last time individual investors really got excited about silver, and they managed to drive it 65% above its 200dma before it finally gave up its ghost! If individual-investor excitement snowballs today, this is certainly possible again.

Another interesting angle to consider is silver seasonality. Not only does silver have very definite seasonal tendencies (thanks to gold’s), but its first three (non-panic-influenced) uplegs all topped in spring. To see a natural silver upleg top in autumn would be quite strange, defying seasonal tendencies for a strong silver rally between November and April. This is also another argument in favor of silver not correcting sharply soon.

Obviously today’s silver peak is very atypical, throwing off mixed signals. It exhibits plenty of technical warning signs that marked the deaths of past major uplegs, and in some cases they are considerably more extreme today than at any past upleg top. But on the other hand, there are opposing factors that suggest silver has room to run yet despite its serious overboughtness. So why even bother trying to call a top? Because silver’s corrections are so wickedly extreme.

After those original three major-upleg tops, silver plummeted an average of 30.1% in just 1.4 months! I’ve heard from many individual investors new to silver and silver stocks today, and I suspect the majority would have a very tough time psychologically weathering a typical silver correction. When silver plunges by nearly a third in less than six weeks, silver stocks get obliterated. 50%+ losses aren’t uncommon. Silver’s violent and unforgiving corrections make looking for tops in this wild metal very important.

So what should we do here given these mixed signals? With silver inarguably very overbought, I would definitely not add any new silver-related longs until we see how this peculiar episode resolves itself. If you have big unrealized gains in silver stocks, you ought to take some profits off the table or at least throw some stop losses on your open positions. You can also buy puts to hedge open positions or speculate on a fast silver retreat. No matter what happens, given today’s extreme silver technicals great caution is in order!

At Zeal we’ve been actively trading this silver bull for its entire existence. This experience is priceless, especially when dealing with such a capricious commodity. The 47 silver-stock trades we’ve realized in our flagship Zeal Intelligence newsletter over the past 8 years have averaged annualized realized gains of +50.3%! Part of this success is due to studying silver itself to better understand the probabilities governing its behavior. And part is due to our extensive ongoing research to uncover the elite silver stocks with the best fundamental prospects to soar.

Though silver is very overbought today and a sharp correction would be totally justified, enough other factors conspire against this to leave us at a fascinating crossroads. I don’t know what silver will do next, but as soon as this metal gives me a better idea I’ll share it with our newsletter subscribers who finance all our research. As this silver bull marches on, we’ll continue to analyze it and look for high-probability-for-success silver-stock trading opportunities in our acclaimed monthly and weekly newsletters. Subscribe today!

The bottom line is silver is extremely overbought today, the run to its latest highs was very fast. There are many similarities between silver’s technicals today and what we saw at this metal’s past major toppings. One of silver’s typical wickedly-unforgiving corrections wouldn’t be a surprise at all. On the other hand, factors such as the lack of gold overboughtness and silver’s seasonals argue that this silver upleg could still have room to run yet. Returning individual investors are getting excited for the first time in years.

Regardless of where silver goes from here, traders need to realize that it is incredibly risky at these levels. Traders with existing longs should consider realizing or at least protecting some of their big gains from this rally. And no new long positions should be added until some of this overboughtness is worked off. Silver is fun when it surges, but its subsequent corrections have destroyed many an unwary trader.

Adam Hamilton, CPA

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