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This Precious Metal Could Land Contrarians Double-Digit Profits

Jim Woods

Silver is getting slaughtered. During the past six months, the price of silver has been bludgeoned, as evidenced by the approximate 35% drop in the value of the iShares Silver Trust (SLV). This exchange-traded fund (ETF), which is pegged to the spot price of silver, has seen nothing but red ink since late November.

The protracted decline in the value of silver has been attributed to many causes, but perhaps the biggest is simply the rotation away from precious metals and into equities.

Technically speaking, silver's chart is about as ugly as it gets. SLV is trading far below the short-term, 50-day moving average and the long-term, 200-day moving average. In fact, the technical breakdown below these key averages took place in February, and it's been downhill ever since.

SLV Chart

To make matters worse for silver bulls, the February decline progressed into a very nasty, near-capitulation sell-off in April that had traders just throwing up their arms and giving up on the metal. Since falling to its April 15 closing low, SLV has slumped another 5.5% before hitting yet another 52-week low on Tuesday.

Now the question is how low can silver go?

Only time will tell, but I believe SLV now trades at levels that should make contrarian traders begin to champ at the silver bit. But why should you be interested in owning SLV here, after the tarnished technical picture and devastating selling we've seen?

To answer this question, we need to consider why silver prices move higher. One reason why people buy silver is it is a safety trade and an inflation hedge trade similar to gold. Another reason why silver prices rise is in response to growing industrial demand, which is largely a function of global growth.

So far, we haven't seen signs of significant inflation, or at least that's what the official statistics tell us. We've also seen some strength in the value of the U.S. dollar of late. Because silver is denominated in U.S. dollars, strength in the dollar tends to hold down the value of hard assets like silver, gold and other commodities.

On the global growth front, things remain tepid, and that's kept a lid on higher industrial demand for silver. There are certainly pockets of modest improvement in the economy and the labor markets in the U.S. and some other regions of the world. However, that hasn't translated into increased demand for industrial metals in general, and certainly not for silver.

Still, if you suspect that we could see either a significant increase in inflation, or renewed industrial demand, then buying SLV at current levels means you are getting in on the silver trade at an incredible value.

The bottom line here is that while silver could still fall from its current levels, I suspect the big damage has already been done.

Moreover, according to recent data from the Commitment of Traders report, or COT, there remains an elevated level of short futures contracts in silver out there (more than 21,000 short contracts as of May 14), which would need to be covered if an unexpected event sends money rushing back into the safety of precious metals. The ensuing short-covering rally would send silver prices soaring.

What would cause such a short-covering stampede? The most likely candidate would be an unexpected spike in bond yields of the sort we've witnessed recently. Or perhaps some exogenous event nobody expects, such as the flaring up of geopolitical tensions. Basically, anything that could send investors back into the safety trade could cause a big rally in silver, especially given the high number of short contracts out there.

For contrarians willing to take a chance on a sector spike, SLV is a great way to roll the silver dice.

Recommended Trade Setup:

-- Buy SLV at the market price
-- Set stop-loss at $19.48, approximately 8% below the current price
-- Set initial price target at $24.35 for a potential 15% gain in three months

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