Understanding how silver futures trading works is integral to understanding what moves silver prices.
The quoted price of silver is typically not the spot price of silver - the price of immediate delivery. Rather, it's the price of the most actively traded futures contract for the delivery of silver in later months.
Manufacturers may use these contracts to lock in future silver prices without having to contend with silver price volatility. Silver dealers may use them to hedge against sharp, unexpected declines. And speculators may just buy up these contracts to make quick profits on violent price movements.
Silver futures trading involves many players and it ultimately is what determines the price of the white metal.
Here's how silver futures trading works...
Silver Futures and Margin Accounts
Rather than buy silver coins or silver bars, a trader can use silver futures to profit off silver price increases - or in many cases, decreases as well.
This is all done through margin trading accounts. Margin accounts are offered by brokerage firms and allow traders to borrow money to purchase assets.
A prospective silver trader will go to a broker and ask to buy a contract for the future delivery of silver at the quoted price. Underlying each contract of silver is the promise to deliver 5,000 ounces of silver during a certain month.
For example, if the quoted price for an ounce of silver is $16, each contract will be worth $80,000. Margin trading allows a silver futures buyer the ability to put down a fraction of the cost of that contract, while still being afforded the ability to take gains on positive price movements.
They'll put down what's called a maintenance margin in their margin account. This is the amount the trader will have to deposit into their account to hold open a position in a silver futures contract.
Let's say the margin is 10%. The silver futures buyer will have to deposit $8,000 into their margin account.
A peculiar thing about futures trading, and this applies to all commodities, is that they are typically cash settled. The underlying silver is rarely delivered. Margin accounts are credited or debited to maintain a margin that is in line with the daily price movements - they are marked to market.
This is how it works...
When a broker is given an order to buy a silvers futures contract, they have to find a counterparty to that trade. They will have to find someone who is willing to sell silver on margin. So if one trader wants to buy silver on margin at $16 an ounce, the dealer will have to match them up with someone who is willing to sell silver at $16 an ounce.
Once again, the silver "seller" is not exactly a silver vendor. They don't readily have 5,000 ounces of silver in inventory ready to be delivered by the date stipulated on the contract. Rather, they are trying to make money on downward price movements of the white metal.
They will put down the same $8,000 margin. The trade is executed and the buyer is matched up with a seller.
At the end of each day, the accounts will be marked to market.
The buyer's account will reflect 10% the price of the contract. When prices move up, to mark the account to market, the buyer's account will be credited and the seller's account will be debited. If prices go down, the opposite will happen.
For example, if the price of silver moves up in one day to $16.25 an ounce, the contract is now worth $81,250. The short seller's account will be debited the amount of the price increase, and it will be credited to the long buyer's account.
That would mean at 10% of $81,250, the short seller's account will be debited $125 to ensure that the buyer's account is up to $8,125.
Conversely, if the price fell to $15.75, dropping the value of the contract to $78,750, the long buyer's account will be debited $125 to reflect the 10% maintenance margin at $7,875. That will be credited on the other side to the short seller's account.
Now that we've explained the basics of how silver futures trading works, here's how it determines the price of silver...
How Silver Futures Determine Silver Prices
Silver futures are paper contracts; most silver futures trading does not actually deal in the physical product. It's done for hedging and speculative purposes.
So when it comes time for delivery of silver as the contract spells out, the trader will cash out. They can either keep the proceeds, or buy another contract for a later delivery of silver. This is how silver futures traders roll over their positions.
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Let's go back to the example of silver being traded at $16. If a trader wants to buy on margin at $16, but there's no short seller willing to sell at $16, then the trade cannot be executed. The price will have to climb up until there is someone on the other side of the trade willing to bet on price declines. That's what ultimately determines the price of a silver futures contract. It's as simple as supply and demand.
The more traders willing to sell than buy, the further the price declines. The more willing to buy than sell, the higher the price increase.
And this is why the price of silver contracts, and not the spot price, is quoted.
For all intents and purposes, the quoted price of the silver future is the spot price of silver through a principle called convergence.
At the time of delivery on the contract, the price of the future will "converge" on the spot price. Let's say it's the day before the contract expires and futures are trading at $16, but silver is trading at $15.75.
It would then make sense for traders, whomever they may be, to try to profit off mismatches in the spot and futures markets. In this case, a savvy trader would want to buy silver at spot, and deliver it at $16 on the delivery date. They will pocket the $0.25 per ounce through arbitrage.
Enough traders trying to exploit this arbitrage opportunity would put buying pressure on spot silver, and selling pressure on the silver futures. This will eventually bring the two prices in line so at the time of delivery, as the new contract period begins, silver futures would be selling at the spot price.
Similarly, if spot silver is trading above $16, at say $16.25, a silver vendor will sell at $16.25 and take delivery of silver at $16, pocketing the $0.25. Once again, buying pressure on futures, and selling pressures on spot will ensure these prices converge.
Jim Bach is an Associate Editor at Money Morning. You can follow him on Twitter @JimBach22.
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