Considering the choppy and volatile metals markets that we are experiencing now — and will probably experience for the foreseeable future — it can be tough to gauge which way the market is going.
Yes, you must take the fundamentals seriously, but, unfortunately, fundamentals have been turned upside down in recent years. Many fundamentally bad investments have gone up and many fundamentally good investments have gone down, and it could make any logical market observer start to question his or her sanity. This is particularly true of precious metals that are used to manage inflation. If recent injections of capital to handle this historic recession brought on by the credit crisis work, we can expect a sharp increase in inflation. If they don’t work and assets continue to decline, metals would be just as volatile.
This doesn’t mean that fundamentals don’t matter. Fundamentals ultimately win, but it appears to be taking a longer time period for supply and demand to play out. Meanwhile, technical considerations tend to be more advantageous in the short-term. Given that, what can a rational metals trader do in the short term?
Today’s crazy and volatile market gives us the opportunity to practice a simple strategy called the long strangle. The long strangle is a market-neutral strategy in that it doesn’t matter which way the price of the underlying commodity moves. Whether it gets more expensive or cheaper is irrelevant; all you want it to do is move far and move fast. The more volatile and extreme the move, the better (see “Volatile times”).
The long strangle is a less expensive version of the long straddle. For the novice trader, the long straddle is simply buying a call option and a put option simultaneously in the same market and at the same strike price. Say gold is priced at $950 and you wanted to do a long straddle. You would buy a call option with the strike price of $950 and a put option with the strike price of $950. Both the call and the put would have the same expiration date. In the case of a long straddle, both the call and the put are said to be at the money (ATM) because the strike price and the market price of the underlying commodity are the same. Because buying both a call and a put at the money can be expensive, a long straddle can be a pricey combination.
As any increase or decrease in the value of the underlying would reward one position, while adversely affecting the other, this is not a directional play. Instead you are betting on an increase in volatility. The higher the volatility, the higher the premium will be for each option, particularly the out-of-the-money option.
A long strangle has the same concept only it’s cheaper because both the call and the put are bought out of the money. In either the straddle or the strangle, the strategy is the same; the buyer is hoping to make a large enough profit on one of the legs of the straddle (or strangle) to offset the total cost of the combination.
For example, say you buy a call option for $300 and a put option for $275. The total cost would be $575. Say the underlying asset skyrockets in price. The call option would gain value while the put would lose value. Presume that the price of the underlying asset rises so much that the call option rises to a value of $700 and the put option plummets to the paltry value of $5. Presume that you cash out both positions. Now what? You have $705 and your net realized gain becomes $130 ($705 less the original cost of $575).Of course, had the price of the underlying asset fallen significantly, the call would have lost much of its value, while the put’s value would have soared.
Keep in mind that the total cost of the call and put combination will be dependent on the strike prices used and the expiration of the options. The closer the strike prices are, the more you will pay. In a long strangle, you aren’t using the same strike price but out-of-the-money strikes for both puts and calls. Because both the call and the put are out of the money, the combination will be cheaper. It is more of a pure volatility play because one side will not automatically be in the money. In addition, the longer the time frame of the options being used, the more you will pay for them. If you choose a three-month expiration, it of course would be cheaper than a nine-month window of time. Remember though that you will be battling time decay, or theta. The nearer your option is to expiration, the more value you will lose to time decay and the rate of time decay will increase the closer you are to expiration.
A simple example of a long strangle on precious metals can demonstrate this concept. The position can be built easily and, if necessary, it can be done relatively inexpensively. For our purposes, the current silver market provides an excellent environment, particularly the exchange-traded fund (ETF) that tracks the metal, Powershares DB silver.
In mid-August, the spot silver market was trading at $14.15 and the silver ETF DBS was at $25.31. The options table for DBS (available at www.cboe.com) shown in “Tabling our options” gives us the farthest expirations available at the moment (January 2010). By press time, it’s likely that options issued for March 2010 will be available.
Because DBS is priced at about $25, a classic long straddle would mean buying a $25 call and a $25 put. Using the options table, such a combination would have cost you $540 ($280 for the call plus $260 for the put) not including commissions. Remember that because you are buying them, the cost is from the “ask” column.
However, a long strangle will be cheaper because you will be buying out of the money. If you buy a $27 call and a $23 put, your total cost would only be $360 ($200 for the call and $160 for the put). If you bought the $28 call and the $22 put, then your total would be $285.
Keep in mind that the long strangle does not have to be done a certain way. There are variations and you can use your creativity and gear it toward your outlook. If you are slightly more bullish than bearish, you could certainly use a call that expires in, say, nine months while the put would expire in only six months.
Time decay won’t increase in earnest until 30-45 days until expiration so that leaves you with plenty of time (see “Make a move”). Ideally you will take profits on this trade well before expiration, around the time Theta begins to accelerate.
Paul Mladjenovic is a CFP, national seminar leader and author of “Precious Metals Investing for Dummies.” He edits the Prosperity Alert newsletter available at www.ProsperityNetwork.net and his blog is at www.mladjenovic.blogspot.com .