November 29, 2006 — In our newsletter dated Sept. 28 of this year (available for viewing at www.optionsellers.com) we recommended put sales in silver in anticipation of an upturn in metals prices. As prices have since rallied substantially, we now feel that the silver market is approaching overvalued levels and that there are currently opportunities to sell calls high above present price levels.
Our view is not necessarily that silver prices will immediately begin to decline. We believe the chances of a sell off are about even, however the chances of silver prices at least slowing their rate of ascent is extremely high, which as call sellers, is all we need to be profitable. This viewpoint is based somewhat on technical factors, but more so on a macro economic view of the factors affecting silver prices.
Granted, silver is not a market that lends itself easily to fundamental analysis. Unlike markets such as natural gas or coffee, where basic supply/demand factors tend to determine price direction, silver takes its cues from a multitude of directions. Like copper, silver can and is used as an industrial metal. Like gold, it also is used as a financial instrument. I have read articles and trader comments tying silver prices to the movement of the dollar, the stock market, crude oil, gold, copper, and even soybeans. I have seen silver prices rise on bullish economic reports, and bearish ones. I have seen it fall on both as well.
The bull’s argument that silver investment demand is tightening up physical supply does not hold water. There has been a persistent rise in silver exchange stocks over the last several weeks, including last weeks expected increase.
The fact is that silver will often track prices of other commodities for certain periods of time. It tends to be affected by whatever commodity market is grabbing the headlines. Thus, when crude oil was falling, investors dumped silver too as fears of inflation eased. When copper prices roared earlier this year, silver followed suit as demand for industrial metals tends to move at the same time.
These days, strength in silver prices is tied most closely to the decline of the U.S. dollar. Silver and gold are often hedges against a declining U.S. currency. And while gold has also benefited from this hedge play, silver has been the darling of the funds. However, with large speculators (read funds) net long 34,456 contracts and small speculators (read “the public”) need long 21,034 contracts, the market looks quite overbought and due for a correction. Any type of reversal higher in the dollar or lower in the U.S. stock market is likely to spook silver speculators enough to drive them to the exits.
A strong stock market typically coincides with favorable economic environment, meaning physical demand may support price. A falling dollar means investor demand should support price. Both at the same time is a recipe for a silver rally and silver has enjoyed such a scenario for several weeks.
The dollar has been pricing in a forecast for slowing U.S. growth in 2007 while the stock market has been feeding off positive earnings reports and jubilant expectations for the 2006 Holiday season. We think that the dollar is declining against other world currencies in expectations of a slowing economy next year. But we think that this decline is nearing the end of its cycle. This view is strengthened by the fact that the dollar is approaching major long-term support. We believe the dollar will require a lot more bearish fuel than a vague outlook for a slowing “rate of growth” to penetrate this support level.
As the U.S. economy slows, other world economies will slow as well, bringing currencies back into balance. In addition to the U.S. dollar gaining back against these currencies, this will also slow physical demand for silver in the U.S. and worldwide. And while silver has recently been trading off its financial instrument properties, it cannot ignore its industrial side forever. Lower copper prices should eventually start to weigh on silver, especially if the gap between the two becomes wider in the coming weeks.
When this happens is open to debate. We are not good enough at timing such events to trade futures contracts. We are not calling for a top in silver prices today. However, if an investor could sell $25 silver calls, all silver has to do is stay anywhere below $25 through expiration for that option to expire worthless. Silver may have the fund interest to push through the $15 or even $16 price level in the coming weeks but we seriously doubt the market’s ability to push beyond these levels – which makes $25 calls look safe.
Traders wishing to hedge their bets while increasing premium collection can also look to sell puts underneath silver at the same time calls are sold. We like the $10 - $10.50 price range for these options. Investors selling this spread, known as a strangle, can profit if silver prices are anywhere between $10 and $25 at expiration. With silver trading just above $14 per ounce today in New York, we think that is a wide profit zone.
