Silver Prices: An Option Trading Strategy That Tells You When to Buy

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"In today's volatile market, picking the right time to buy silver is something of a guessing game. But if you are familiar with options, you can let them be your guide in learning precisely when to buy."

As last week's Money Morning special report pointed out, the long-term fundamentals for silver prices are decidedly bullish.

However, in today's volatile market, picking the right time to buy silver is something of a guessing game.

But if you are familiar with options, you can let them be your guide in learning precisely when to buy.

And here's the best part: This option trading strategy will only cost you a few dollars.

It works with either options on silver futures - e.g., the standard 5,000-ounce Comex contract, recently valued at around $140,000 - or any of the much more affordable silver-based exchange-traded funds (ETFs) on which options trade.

Taking the Guesswork Out of Silver Prices

For ease of explanation, I'll base our example on the iShares Silver Trust ETF (NYSEArca:SLV), recently priced at $27.34. For comparison purposes, the price of a single SLV share typically tracks the price of one ounce of silver, but is usually $0.75 to $0.80 lower.

Here's what you do:

  • Buy an out-of-the-money call option with a strike price $1.00 to $1.50 above the current price of the underlying SLV shares and an expiration date three to six weeks out. In this instance, with SLV at $27.34, that would mean buying a June $28.50 call, priced at about $0.44 a share, or $44 for the full 100-share contract.
  • You would also simultaneously Sell an out-of-the-money put option with the same expiration date and a strike price a dollar or so below the current SLV share price. In this instance, that would mean selling the June $26.00 put, priced at about $0.40 cents, or $40 for the full contract.

The cost of the combined position is thus just $0.04, or $4 total.

For simplicity's sake, I'm using single options in the example. In practice, you'll buy and sell one option pair for each 100 shares of SLV you want to purchase, and the cost will rise proportionately.

You will also have to post a margin deposit to cover the sale of the short put. In this case, that would be about $412—but you'll get it back unless the put is exercised and you get to buy SLV at $26 a share.

And what do you get for your $4?

Quite simply, you get a position that takes the guesswork out of the decision to buy silver—or, in this case, shares in the SLV silver ETF—and cushions you against limited short-term volatility.

Between now and the June 15 option expiration, SLV share prices can fluctuate all they want between $26 a share and $28.50 a share, and it won't affect you one way or the other.

You can just calmly sit and watch, waiting for silver prices—and SLV—to make a more decisive move.

If it does, one of two things will happen:

  • SLV will break out of the recent trading range to the upside, moving above $28.50 a share. You can then exercise the call and buy the shares at that price—regardless of how high SLV's price might have moved above that level. (Alternatively, you can simply sell the call just prior to expiration.)
  • SLV will fail in its next rally attempt, with the price turning lower and falling below $26 a share. The put will thus be exercised and you'll have to buy SLV at that price—a substantial bargain over what you'd pay if you merely bought the shares today. (Again, if you prefer, you can just buy back the put shortly before expiration.)

Either way, you'll have avoided a lot of anguish over when to buy and whether you've made the right decision.

Plus, as Table 1 illustrates, if silver prices rally substantially, you'll make almost as much profit as if you'd laid out the $2,738 to buy the actual shares in the first place—and your return will be far, far higher.

Breaking Down the SLV Trade

For example, if SLV rose to $35, you'd make $766 in profit, or 28.0% on the shares.

But, on the option combo, your profit would be $646 (reduced by the out-of-the-money amount of the call, and the cost of the combo)—an incredible gain of 16,150% on your $4 cost.

silver1

Even if you count the $412 margin deposit as part of the cost, the return is still a whopping 155.2%.

Even better, if silver prices fall and SLV drops below $26.00 a share, your loss is actually $130 less than if you had purchased the ETF itself—simply because you avoid the entire decline from $27.34 to $26.00.

And, if silver goes nowhere, you're out. . .yeah, four bucks.

As noted earlier, this play can be used with any number of options on SLV or the other silver-linked ETFs that have options, as well as with the options on the Comex futures, though the numbers—cost, reward and risk—will be substantially higher with those.

Be aware as well that the selection of option strike prices should involve a little more analysis than the generic guidelines offered here.

In reality, if you plan to seriously utilize this strategy with silver—or any other stock or commodity—you should first examine a technical chart for the underlying security, then buy calls with strike prices just above primary resistance levels and sell puts with strike prices just above major support.

That way, you'll be buying the underlying security only on a confirmed breakout, or at a bargain point where the price is unlikely to go much lower.

Larry Spears
Money Morning

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