Backwardation in gold and silver

Posted | 05/05/2015 / Views | 3474
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We’ve written about gold and silver having been in and out of backwardation over the last couple of years but it is a concept hard for some to grasp.  Bill Holter, as he often does, gives us a simple to understand explanation…

“As a question to set the foundation, I ask you this; if you could sell something today for $100 and be contractually guaranteed to be ABLE to buy it back 30 days later at $99, would you do it?  I hope your answer is not only yes, but you return with "how many times can I do this, it's free money?!".  In the real world, this is called arbitrage.  Rarely does the condition ever exist on a single exchange, normally when it does exist it happens over two or more exchanges and even time zones.  The discrepancy can be miniscule as billions of dollars scan the globe 24 hours a day looking for this situation and lock the profit in until there is no more to be had.  Arbitrage is a big business and for the most part, RISK FREE.  The condition described above is called "backwardation", the remedy is ALWAYS arbitrage.  

Please notice I bold [capitalised] printed three words, "able, risk-free, and always".  Starting with the first word "able", if we changed that word to either possibly or cannot, the whole equation changes as the trade is no longer risk free and will not ever be done without risk assessment.  As I understand it, physical gold is in backwardation in London and silver in Asia.  Why has not big money stepped in and arbitraged the "guaranteed" profits out of these markets? 

The answer of course is that the profit is not guaranteed.  The reason backwardation is persistent is because the fear of not being able to get your metal back 30 days into the future.  It is being deemed by the market that gold today (a bird in the hand thing) is more valuable than a "promise" to get it back in 30 days ...because promises are made to be broken!  The fear obviously exists of a failure to deliver in the future, there can be NO other explanation why physical gold in hand is more expensive than gold 30 days in the future.”


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