While painful for long-term investors, the bear markets in both stocks and commodities, which intensified in the fall of 2008, have produced two market conditions that are extremely favorable to option selling: long-term trends and volatility. A perfect example of this is in the silver market. Silver prices have declined more than 50% from mid-July through mid-December. The market is oversold, even though the trend leveled off into year’s end. But the fundamentals driving silver’s decline remain intact. The U.S. dollar, despite America’s economic woes, remains a flight to quality currency for the world, at least for the time being. A strong U.S. dollar keeps pressure on inflation hedges such as gold and silver. But silver also doubles as a commercial metal, used in everything from jewelry to computer chips. A slowing U.S. and global economy has cut demand sharply across a swath of product categories. It is this dual reduction in both consumer and investor demand that has driven silver prices to their current levels.
Until one or both of these conditions are alleviated, the overall trend in silver prices is not going to change.
A trader successfully riding a trend is much like a surfer successfully riding a wave. Sooner or later, you’re going to fall off the board but not before you’ve had a great ride. Selling options with a long-term trend is a way to rack up premium month after month with little stress, as long as the trend remains intact. Eventually the trend will change and you may (or may not) lose money or break even on your last set of options. If you’ve done it correctly, however, this last trade will only put a small dent in a profitable trade.
While the media pundits and long-equity biased analysts try to give themselves hope that a bottom is near, you have some of the best long-term trends available for trading in the last 10 years. If you are overlooking these because of bailout and recession headlines, perhaps you will want to take another look.
No one knows where the bottom is or when these trends will change. However, implied volatility has made it possible to sell options so far out of the money that, even in the event of a trend reversal, option writers will have plenty of cushion.
A rally in the stock market and/or a pullback in the dollar would almost certainly bring some fund buying (at least short covering) into the silver market. Silver prices could rally to $14 an ounce before encountering any significant resistance. While a technical bounce of this magnitude would be extreme, you may want to consider a trading strategy that could accompany such a move and still remain intact.
Obviously, option selling with the trend, in this case, would mean selling calls, as almost all commodities markets are in downtrends. But we will suggest a twist with this trade.
Our suggestion is a strangle. Implied volatilities for silver options are still near six-month highs. This means that you can sell options further out of the money. For instance, call premiums of $500 to $600 are available at strikes in the $19 and $20 levels for the May contract. That’s more than 100% out of the money and well above the $14 resistance levels. Barring an abrupt and complete trend reversal, these strikes should be safe bets for premium collectors.
However, a strangle is a sale of a call and a put. In a strangle, a move against one will often be a gain for the other, at least to a certain degree. As the put and the call have a “baby-sitting” effect on one another, it builds a stronger more resilient position. Eventually, as long as the futures price remains above the put’s strike and below the call’s strike, both put and call expire worthless — exactly what the strangle seller wants.
To balance the sale of the call, we put strikes in the $6 range for the same contract months. Strikes in this range are offering premiums in the $600 range and are nearly 35% below the current price of silver. The shorts will have a hard time pressing prices much lower in the short term given the oversold nature of the markets. However, profits from the call sale will help keep us in the put if we are wrong.
Our gut feeling is that silver will experience a corrective rally at some point this winter, followed by a consolidation back towards or below the lows. And if the global recession causes a massive sell-off or if inflation concerns create a huge rally, profits on one end of the trade would offset losses on the other and at least to a certain extent the profit zone of the spread is so wide ($6 to $19) that you have a lot of room to be wrong and still make money. We can’t say as much for the stock pickers.
James Cordier is head portfolio manager of Liberty Trading Group. James’ market comments and option strategies are featured in numerous media outlets. Michael Gross is a market analyst with Liberty. Together they wrote “The Complete Guide to Option Selling” (McGraw-Hill 2005). They can be reached through their Web site, www.OptionSellers.com.