In short, the silver spot price is determined by silver futures, but before we get into that, I want to explain some basic concepts, like:
- What is a futures contract?
- Whats are silver futures?
- How does the COMEX work?
What is a futures contract?
A futures contract is a contract that is traded on a special stock exchange called a futures exchange. You buy or sell an instrument, like silver or gold, at a certain date in the future, at a specified price. Basically, when you buy a futures contract, you´re making bet that something will be worth something at sometime in the future. The advantage of trading futures contracts is that they are purchased on the margin, so it’s possible to make huge profits from a small investment. The disadvantage is that if you lose, you pay the full amount (not on the margin).
If this seems like a crazy way to buy silver, you would be correct because most purchasers of futures contracts never take possession of the underlying asset (silver in this case). We call this type of buyer a speculator. Speculators try to profit from from future price changes. Although speculators are often demonized by the media, they actually provide an important market function and help to hedge against rapid rises and falls in commodity prices.
When people speak of “paper silver” they’re often referring to silver futures contracts. The problem with the gold and silver futures market is that the paper “inventory” exceeds the physical inventory by an alarming amount, providing a mechanism to manipulate gold and silver prices. But that’s a discussion for another article.
Whats are silver futures?
As you may have already guessed, silver futures are simply futures contracts where the commodity is silver. Silver futures contracts can also be called futures contracts, or simply futures, depending on the context. Futures contracts for silver are usually made in 5,000 troy ounce increments. Silver futures trade on many exchanges around the world. In the US, silver futures are primarily traded on COMEX, an abbreviated name for the former Commodity Exchange, Inc., which is now owned by the CME Group.
All silver futures traded on COMEX must specify 5,000 oz. of 99.9% pure silver (five 1,000 oz. silver bars) made by a COMEX-approved refiner.
When trading futures, traders must follow certain rules, but the only variables that are decided during an auction are:
- Whether you are buying or selling.
- Your price. If you’re buying, the “bid” price is the price you’re willing to pay for the contract. If you’re selling, the “ask” price is the price you want for the contract.
- The quantity of contracts you want to buy/sell.
Price discovery occurs via the auctioning process as buyers and sellers determine what is in their best interests. Later, we’ll discuss how the silver spot price is determined via silver futures pricing agreements.
Spot Trades vs Futures
A spot agreement requires immediate payment (within a few days), and delivery of the silver follows immediately after payment is cleared by the seller. When you buy silver coins or bars from your LCS, it is considered a spot trade. This is why silver dealers use the silver spot price to determine the price of their coins and bars.
Like spot trades, a futures trade is a price agreement in the present. The difference is, however, that payment and delivery occur during a future contract delivery month. The contract reflects the buyer and seller expectations of future silver prices.
How does the COMEX work?
Nearby Contract Months
As a futures contract month approaches in time, it becomes “nearby” and eventually becomes the current delivery month. Contracts with current-month delivery dates cease to be futures and become cash-for-silver transactions.
At the COMEX:
- The current delivery month ends on the third from the last business day of the calendar month.
- The next, current delivery month begins on the second to the last business day of the previous calendar month.
The nearby silver futures contract month typically means the closest month when the silver bullion may be delivered and the contract expires.
Active Contract Months
During certain contract months, trading at settlement (TAS) is allowed. This means a trader can liquidate (exit) an open position with an offsetting trade ending the requirement to exchange silver for cash. Because of this option to offset a futures contract without having to deliver physical silver, trade volumes are much higher during active contract months.
At COMEX, the active contract months for silver futures are:
In the COMEX, the active contract month is the nearest, but not current, base contract month. For instance, if the current month is May, the active contract month for silver futures is July. During contract months that have very low trading volumes, exchanges discover spot prices from nearby active contract months with higher volumes.
Where’s the silver?
In the US, depositories approved by COMEX store the silver bullion involved in futures trading. As noted earlier, however, the actual physical deposits are much lower than the amount of paper contracts at any given time. It has been reported that at some times, paper silver ounces have exceed physical silver ounces by a ratio of 500 to 1. What do you think would happen to the price of silver if too many traders tried to collect their contracts in physical form?
If you purchase a futures contract and hold onto it until it is completed, you can take delivery of physical silver. However, after the silver leaves the COMEX network, it must be assayed if you want to sell it on COMEX. Having silver assayed is a certification process that ensures your silver meets COMEX specifications, and of course this costs money.
Should You Buy Silver Futures?
Personally, I would never buy silver futures. First of all, I have a moral objection to trading paper representations of physical commodities that don’t exist; silver futures are the fractional-reserve banking of commodities. Secondly, silver futures require considerable experience and knowledge and even then, they carry a high risk. When they system implodes, you’re better off holding physical silver bullion instead.