Autocalls Syndrome In The Silver Market

By: Submissions

François Lenôtre writes: Autocallable products, or “autocalls” are structured notes popular primarily in Asia but also, to a lesser extent, in Europe. They offer the buyer an enhanced coupon linked to the behavior of an underlying market. With rates currently so low, vast amounts of autocalls linked to equity and commodity markets have been sold to investors, enabling them to receive 10 to 15 % annual yields (sometimes more) with the risk of seeing their capital wiped out in case of a collapse of the underlying reference market.

Silver autocalls were particularly in demand in 2012 and 2013 with maturities mostly concentrated between 2015 and 2016.
To schematize, the buyer of the note sells, in fact, embedded in it, a binary option to the note issuer. This is how the issuer is able to pay a yield above market rates; he simply pays the option premium over time, under the guise of coupons.

For those unfamiliar with binary options, the principle is quite simple: let’s say that silver spot is trading at 28 $; if I sell a 1 M$ American binary option with a barrier at 16$ and a 3 year maturity, I will receive a certain premium commensurate with the level of 3 year implied volatilities in silver options (let’s say 200 k$). However, if at any point during those 3 years spot silver trades at or below 16$, I will have to pay 1 M$. Because of this feature, the note buyer is at risk to see his capital evaporate.

Tens of millions of dollars of binaries have been implicitly sold, as they are embedded in those structured products, by note investors with strikes (more commonly designated as binary or digital levels) ranging from 16$ to 14 $.
In 2012 and 2013, silver implied volatilities were still attractive and enabled note issuers to pay high coupons making those investments attractive to silver bulls who thought spot would never trade at or below 16$.

Those binary options expire, as we said above, mostly between 2015 and 2016.
The most interesting feature of this situation is its effect on spot silver.

The following might seem a bit complicated but is key to understanding the present behavior of spot silver and, maybe, its future behavior. I will try to explain it in the simplest terms but if you are interested, numerous technical papers are available on Internet describing this type of options and their delta management.

The note issuers own what amounts to a lottery tickets. If silver touches a few barriers at or below 16$, they will receive tens of millions of dollars in payout. Banks are managing these notes and, contrary to popular opinion, bankers are not in the business of buying lottery tickets but in the business of risk management (I know this will elicit a few smiles).
Suppose you own a lottery ticket which will pay, let’s say, 1M$ if silver touches 16$, what would you do? Well, there is a mathematical answer to that and without going into boring details, you have to buy some silver all the way down.
This is in case it never reaches 16$ and the binary option expires worthless. Once you have bought scale down the silver, down to 16,01 $ or more, it either goes back up (and you sell it back scale up, making a profit which compensates you for the “non triggering”) or it goes down to 16$ and you receive your payout but you have to sell back the useless silver hedge, taking a loss between your average buying price and your selling price.

The point is that you can repeat this process until the trigger is touched or the option expires. This explains the recent behavior of the spot market, which looks like a ball rebounding lower and lower off the 18,2 / 18,60 level.
There are tens of millions of ounces (and in the coming months hundreds) to buy scale down below 20$ and above 16 and tens of millions to sell back above those levels. With time going by, the necessity to buy and sell more aggressively is pressing, as you need to make up for the likelihood of the barriers not being triggered.

What happens next?

That’s the 1 million $ question; either natural demand lifts those offers from the notes managers and we go up, far away from the 16 / 14 $ level or we trigger the binary options and there will be a drop down to the 10 / 12 $ level which will be the buy of a lifetime. Will we escape the 14 / 16 vortex? Your guess is as good as mine.

Copyright © 2014 François Lenôtre - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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