It is no secret that the raging bull market in commodities got caught in the teeth of a bear in the second half of 2006. The rapid advance in prices in everything from gasoline to sugar eventually hit a point in the demand continuum where consumers cried “enough!” It is a basic economic concept. Eventually, in any bull market, prices will reach a level where higher prices will cut demand and thus, prices begin to recede.
When this happens, as it has recently in the crude oil, sugar and silver markets, speculative funds that generally follow trends will tend to jump on the train and begin liquidating positions as the trend reverses, often accelerating the descent in prices. Eventually, however, this phenomenon begins to work in reverse as lower prices begin to spur demand, thus increasing price and the cycle begins anew. Despite the media, who now sit firmly on board the bear market bandwagon, we think this level is close to being attained in a variety of commodities, including silver, gold, natural gas, sugar and copper.
Picking the bottom of a market can be tricky, however. Trying to buy futures contracts at the end of a trend can be a frustrating, and sometimes costly, endeavor. However, it can be a situation custom made for put selling. And of the markets mentioned above, the volatility in gold and silver appear to make them the ideal candidates for writing put premium now.
Although there is a degree of loose correlation between several commodities markets, prices of each individual commodity tend to answer to their own fundamentals. Thus, one cannot say that all of the commodities ran into a bear market at the same time, any more than one can say that all commodities have participated equally in the bull market. This also uses the term “bear market” quite loosely. There is a big difference between a bear market and a bull market correction. At this point, we are nowhere close to a real bear market in commodities. Although there have been some rapid price declines during the last few months in several markets, a look at the longer term commodities index should help one to put these declines into perspective. Although the future remains to be seen, we presently appear to have nothing more than a short-term correction.
Investors, and to a greater degree the investment media, are a finicky bunch, and despite all of the conventional wisdom they preach, tend to focus on the short term and disregard the longer term. The focus on the recent deflation in crude oil prices along with a handful of other commodities has everyone talking about the fallout from the “bear market.” Yet, the error of this type of thinking is that this rapid commodities price decline, especially in how it relates to crude oil, is exactly the catalyst to fire up world demand into the fourth quarter of 2006. While the rapidly expanding world economy may have taken a breather over the last several months, the world is not much different, at least economically, than it was at the height of the commodities boom.
Oil at $65 a barrel (or lower), will not only provide more disposable income to the U.S. population, it will spur global economic growth, which combined with already lower prices in other commodities, should begin increasing demand for these commodities. Thus, the very bear market in oil that is so widely discussed is exactly the catalyst to reverse the waning demand in industrial commodities.
The Chinese economy, widely touted as one of the main engines that drove the fierce bull market in copper, may be one of the first coming back to the table. Although copper prices held up rather well during the last six months, prices have nonetheless receded, as Chinese buyers were unwilling to pay the high price producers demanded. But there are early signs that copper may be reaching value levels, making it more attractive to buyers. China’s ministry of commerce announced this week that China’s copper demand could grow 5.6% this year to 3.8-million metric tons. This is a substantial increase from last month’s estimate of only 3% growth in 2006. Copper bulls eagerly awaiting China’s return to the buyers table may get their wish in the fourth quarter of 2006.
But copper options do not seem to offer the liquidity or the premiums that you can find in the more glamorous silver and gold options pits.
Our view is that if commodities are indeed in only a corrective phase, the metals markets could be the first to begin leading another advance higher. Despite mild concerns about this week’s U.S. gross domestic product (GDP) report for the second quarter, when oil prices were testing the $80 level, we remain moderately bullish the U.S. and second-world economies, especially with energy prices seeming to have come under control. This week’s surprise increase in new home sales readings supports our views.
While copper primarily is an industrial metal, gold is more of a financial than industrial market with its value influenced by currency fluctuations, interest rates and geopolitical events. Gold’s primary physical use is in the making of jewelry.
Silver borrows attributes from both copper and gold in that industrial or investor demand sways its price. However, unlike gold, roughly 45% of world silver demand is for industrial use. Therefore, if global economies are indeed benefiting from lower oil prices in the fourth quarter, industry should be the first to benefit, spurring the demand for silver over gold.
We like silver as a market for selling puts, in that, one does not necessarily have to see prices move higher to profit. For sellers of puts, the market must only remain above the put option’s strike price through expiration. The market appears to have breached a solid value level and prices seem hesitant to push much lower than the $11 price range. With commercial buying coming into the market at these levels, we foresee an increase in Chinese and Indian demand close behind.
While we will not go as far as projecting a wildly bullish advance in silver in the fourth quarter, we feel it a solid bet that silver prices will remain above $9.50 an ounce for the near future and believe selling put premium below these levels is an excellent strategy for fourth-quarter income. Implied volatility left over from the price moves of the last 90 days leaves attractive premiums still available in these puts.
James Cordier & Michael Gross
Liberty Trading Group
401 East Jackson Street
Suite 2340
Tampa, FL 33602
(800) 346-1949
www.optionsellers.com
James Cordier is head trader and president of Liberty Trading Group, a futures brokerage firm specializing in option writing on commodities. James’ market comments are published by several international financial publications and worldwide news services including The Wall Street Journal, Reuters World News and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Cordier and Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers.
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
