Seven Reasons A Boom In Silver Is Beginning

With gold and oil hogging the “commodities spotlight,” silver is too often forgotten. However, a new trend is emerging that indicates a major rally may be starting in silver prices and silver related stocks.

Over the past few weeks we’ve seen more and more data that supports a rally in silver: from large institutional money making large bullish bets, to technical indicators of a breakout, fundamental valuations well below where they should be, and a possibility of a massive short squeeze.

The iShares Silver Trust ETF (SLV: 15.57 +0.22 +1.43%) has gained 18% since the broader markets began to rally in early March, but we could easily see another 25% - or more - in the remainder of 2009.

All in all, they make silver a must-own in any diversified portfolio.

Here’s what the smart money is doing in silver right now, seven reasons we could see a rally in silver prices and a few ways you could position yourself to profit handsomely.

Following the Smart Money

Like gold, silver isn’t just for jewelry and currencies. It is used for many industrial applications, having the highest electrical conductivity among all metals. Silver’s uses require over 832 million ounces for fabrication into and for products every year.

More than 60% of silver production is a result of the byproduct of copper, zinc, and lead mining, which has slowed substantially due to the economic slowdown. And production will remain halted until we see significant economic recovery. In order words, nothing looks to increase silver supply any time soon.

Silver is also a commodity that can be used as an inflation-hedge. With the recent “Dr. Doom” report that the United States is heading into a period of hyperinflation, silver is looking like an attractive alternative to gold.

And the big money is starting to move into this golden alternative. I’m a big fan of following the professional “smart money” flows for insight into their outlook. Last week we got a huge signal.

On Friday, a massive options trade took place in the Silver ETF where a trader implemented a strangle selling strategy using the January 2010 $19 calls and $13 puts, to finance the purchase of 75,000 January $14 calls.

The trader sold 100,000 strangles, so price of the January $14 calls only cost around $0.23 each due to the ratio used. An institution or large investor is making this bullish bet with a lot of conviction regarding where silver prices are heading.

For those of you not as familiar with options trades, this was a $2.25 million bet that silver will continue to rise throughout 2009. This trade could yield $37.5 million if SLV climbs above last summer’s levels of $19. They would lose large amounts of money if silver were to head lower.

Another way to look to see what the “smart money” is betting on is in the Commitment of Traders Report for Silver. It showed that as of Friday large speculators are long/short the silver futures at a 6:1 ratio, while the small speculators are long nearly 3:1. The smart money is betting big at almost twice as much as smaller investors.

It has been speculated that the silver market is so tight that if these speculators were to call for physical delivery of the commodity, prices could explode higher as the system is not prepared to handle that possibility.

Data from the World Silver Survey shows that supply of silver has basically been unchanged the last 9 years, while demand has also remained steady. Take a look below.

You’ll notice that demand has fluctuated over the years, but industrial application have been increasing. This should continue as the economy turns around.

Seven More Reasons Silver is Going Up

But for those of you who don’t trust the actions of a few institutions and professional traders, let me also offer a few more reasons why silver demand will surge and prices will go soaring…

• A large short interest in silver along with the backwardation in prices could cause a massive short squeeze - The shorts do not have the physical silver needed to meet current obligations, and will be forced to buy at progressively higher and higher prices.

• For the technical traders who like using charts, Silver ETF (SLV) carved out a perfect cup and handle pattern on the weekly chart looking back to early 2008. It broke out of the handle in early May putting an implied target of above $19 on Silver.

• The fundamental picture also offers a bullish view on where the price of silver is headed. Silver, more volatile than gold in terms of prices, has had a supply deficit for nearly 20 years and the demand continues to surge, but supply is dwindling as shown in Friday’s report that Mexican silver output fell 54.7% in March from a year ago.

• Silver mine production has been steadily declining over the years. There are many who believe it will be one the first element to become “extinct,” possibly as soon as 2020. That remains to be seen, but the fact that it’s being reported starts to tell you just how much stockpiles have dropped.

• The historic gold/silver price ratio is 15:1. With gold now approaching $1000/oz, the ratio is currently at 62:1. In order for that ratio to come back into its historical range, silver would have to jump to over $65/oz.

• With no slowdown seen in gold prices, brought on, in part by the declining U.S. Dollar as large amounts of government stimulus money is pumped into our economy. If the BRIC nations of China and India start buying the silver as an alternative to US Dollars or Treasuries. Silver could see a massive jump in prices.

• A recent Wall Street Journal article stated that March sales of Silver Eagle coins surged 900% from the prior month, and $1 face value coins are selling for more than $30 on EBAY. Supply has grown so tight due to the high demand for industrial uses that the U.S. Mint had to halt production of American Eagle silver coins.

Playing the Silver Boom

Investors can play the silver boom in a number of ways: buying the physical bullion, buying the iShares Silver ETF or the ProShares Ultra Silver ETF (AGQ: 55.68 +1.32 +2.43%), or through investing in individual mining companies with a large exposure to silver, and finally options on these securities.

Some individual mining names to take a look at include: Silver Wheaton (SLW: 10.64 +0.15 +1.43%), Pan American Silver Corp (PAAS: 23.73 +0.34 +1.45%), and Silver Standard Resources (SSRI: 24.62 +0.32 +1.32%) represent some of the larger more stable companies.

More speculative names include Coeur d’Alene Mines (CDE: 14.22 +0.02 +0.14%), Hecla Mining (HL: 3.76 +0.06 +1.62%), Mag Silver (MVG: 5.78 +0.13 +2.30%), Endeavor Silver (EXK: 2.30 +0.04 +1.77%) and Silvercorp Metals (SVM: 3.27 +0.02 +0.62%).

When looking for a silver mining company you want a firm with good management, large proven reserves, strong cash flow with strong balance sheets, strong relative ROE (return on equity) and ROA (return on asset) ratios and a positive short-term production forecast - paying attention to silver reserve/resource ratios, or how much they’re producing relative to how much they have in the ground still

Regardless of the approach you take, having exposure to silver could pay-off in a big way - while at the same time offering safety as an inflation hedge. And signs of an economic recovery later this year will bode well for the precious metal as production ramps higher and industrial uses increase.

Either way, it’ll pay to add silver to your portfolio.