'Riding the metals bull market

There are several bullish factors coming into play at the same time that should continue fueling the bull market in precious metals. Greater demand for the physical metals by expanding economies, an exchange-traded fund (ETF) on silver, record high prices in crude oil, geopolitical tensions and uncertainty are all contributing to the highest prices we’ve seen in the precious metals markets in more than 20 years. Spot silver reached a 23-year high on April 20, when it hit $14.69 per ounce. Spot gold surged to $634.50 per ounce, the highest level since December 1980. This is an increase of 103% in silver prices and 47% in the gold throughout the past 12 months.

In the earliest stages of this bull market, silver was just being dragged along by the gold. Gold has been rallying aggressively since August 2005 on strong physical demand by both China and India. According to Chinese President Hu Jintao, China’s economy grew at 10.2% in the first quarter this year. India has an annual growth rate of nearly 8%. We do not anticipate either of these two economies to stop expanding any time soon. This growth will continue to support higher prices in both gold and silver.

Recently, silver has had a leading role in precious metals in anticipation of a silver ETF, launched April 28 and registered by Barclay Global Investors after having gained approval by the Securities and Exchange Commission (SEC). Barclay Capital Inc. has already deposited 1.5 million ounces of silver with a custodian to back its ETF. The popularity of the ETF will help determine what the physical demand for silver will be, because all of the issued shares must be backed by the silver bullion. Also, keep in mind that silver can be categorized as either precious, when being used for jewelry, or industrial when being used in electronics, photography or in multiple medical uses.

Crude oil prices continue to climb as geopolitical tensions remain high. Gold and silver are viewed as a safe haven in times of geopolitical tension and economic uncertainty. Crude has helped to drive metals prices higher, a trend likely to continue. Silver at $25 an ounce and gold at $850 to $1000 an ounce are a possibility throughout the next three to four years. Until the price of precious metals close below the 200-day moving average or the fundamentals drastically change, the long-term picture remains bullish.

However, to stay long in these markets for a prolonged period, you want to make sure you don’t overleverage your account. You have to be able to withstand pullbacks and corrections. No market continually rises without pullbacks; the precious metals are no exception. Traders should get long on pullbacks near major support levels or consider a long-term bullish option strategy with limited risk.

One example is a long-term bull call spread. By buying a close-in call and selling a further-out-of-the-money call against it, you define your profit/loss potential. As of early May, we like buying the December $16/$20 bull call spread. The net cost of this spread based on the May 1 open is roughly $0.60 per ounce or $3000 per contract (excluding commissions and costs). Your total risk is the amount paid for the spread. The spread’s profit potential is $4 per ounce minus the total paid for the spread. Because one contract of silver is 5000 ounces, the potential is $20,000 minus $3,000 plus commissions.

You would buy the December silver $16 calls at $1.35 per ounce and sell the December $20 calls at $0.75 per ounce. The difference in the premiums is the cost of the spread, $1.35-$0.75=$0.60. By selling the $20 call, you help pay for the long December $16 call. To figure out the potential of the spread all you do is figure out the difference in the strike prices, $20-$16=$4, and subtract your net cost of $0.60. This spread expires on the close of the market on Nov. 27, 2006. This strategy can be applied to other markets as well.

The fundamentals and technicals are indicating a continuation of higher price patterns in metals. Gold could reach $800 and silver $20 by year-end and we anticipate even higher prices the next few years. But taking advantage of these moves can be difficult because of the added volatility, so one must develop a plan to handle it.

Frank J. Cholly and Frank D. Cholly are market strategists for the Lind Plus broker-assisted division of Lind-Waldock.

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