Time to Get Short on SilverTime to Get Short on Silver: Options Plays, Part 2
By Ben Abelson
04 Apr 2006 at 04:27 PM EDT
NEW YORK (ResourceInvestor.com) -- In just the past two months, silver’s gone from red-headed stepchild to front page news. But while the long-term fundamentals of the bull market remain in place, the level of hype that has permeated the market may soon create the perfect opportunity to get short on silver.
Several respected pundits have begun to quietly float this idea. In a research note just days ago, for example, Bob Hoye of Institutional Advisers said, “with the imminent arrival of the ETF the upside market momentum is stretching the technical indicators to levels not seen in years. The monthly chart is generating upside exhaustion signals.”
The pending ETF listing combined with a fast-moving spot have combined to push silver to 20 year-plus records in the past few weeks. But while the new ETF probably bodes well for longer-term investment interest in the sector, it may mean that the metal has (or will shortly) make a near-term top.
Research from J.P. Morgan also seems to confirm this trend. Analyst Anindya Mohinta recently noted that gold rose by up to 12% in the 90 days prior to an ETF listing (there are seven gold ETFs worldwide), but dropped by anywhere from 7% to 10% in the three months following the listing date.
Given the manic, illiquid state of the silver market investors can expect any decline to be fast and furious. However, with silver’s tendency to head-fake investors – and the fact that market is particularly vulnerable to a short squeeze – I would not expect silver to decline immediately. Rather, the metal seems more likely to push its way up toward $12 per ounce before making a potentially nasty decline.
At that point the easiest way to play the short side of silver will be via a bear put spread, the exact opposite of the bullish options strategy recommended to investors in early February – when silver was trading well under $10 per ounce. Our last option trade on silver turned out to be quite profitable. Our September 7.5 calls purchased under that strategy more than doubled in value at their peak, and investors who timed their trade carefully would have been able to enter into a profitable spread quite easily.
(Note: Implementing and understanding this strategy does require an intermediate knowledge of options trading, as well as a brokerage account enabled for both buying and selling options.)
Implementing a Bear Put Spread on Hecla
A bear put spread allows an investor to place a bearish bet on a given market or equity. We’ll enter into our spread with the goal of keeping the play essentially riskless by selling short options of an earlier month.
The easiest way to get into this trade is to target a fairly liquid silver equity, preferably one that tends to track the moves in the underlying metal. For our purposes, we’ll take a look at Hecla Mining [NYSE:HL].
Since Hecla’s had some weakness over the past few days, I’d recommend investors hold off purchasing puts on the hopes that we some strength over the next couple trading sessions (making the puts significantly cheaper).
For example, with Hecla trading in the $6.6 range, investors should be able to purchase 10 September 5 puts (HLUA) in the neighbourhood of 35 cents per contract – for a total cost of $350, plus commissions. With this purchase, the investor would have entered the first leg of the spread. The ultimate goal would be to cover all or part of the cost of the purchase through the sale of puts with an earlier expiration date. (Recently, however, Helca’s put have actually traded for less than the theoretical value derived from a standard options calculator. Obviously, if you can get these puts for less, you should go for it!)
With some decent short-term declines in Hecla, an investor could then sell 10 June 5 puts on Hecla for almost the same price. Given Hecla current volatility, a 10% decline from current prices (certainly not unthinkable given silver’s overbought level) within the next two weeks could bring the June 5 puts up to 30 cents per contract.
The Situation
By selling the June puts at that level, an investor would be able to leg into a bearish Jun 5-Sept 5 put spread at a cost of only $50, plus commissions. This spread allows an investor to participate considerably in Helca – and silver’s – near-term downside potential, but with minimal risk.
Of course, investors looking for higher rewards could attempt to scale into this trade using any multiple of option contracts.
Let's review how this spread could play out based on several different trading situations. The core things to remember are that options are valued not just on the underlying stock price, but also on the time until their expiration and on the underlying stock's volatility (among other factors).
One Month to Expiration
It's mid-May, 30 days until expiration of the June 5 puts. Let's take a look at what our calendar spread would be doing with Hecla trading at several different price levels.
Hecla at $7
With Hecla at $7 in mid-May, and volatility levels the same as today, the June 5 puts would be essentially worthless, while the September 5 puts would be worth about 20 cents, according to our options pricing calculator. If Hecla’s still up at these lofty levels in mid-May, the best option would probably be to beat a hasty retreat! An investor could opt to buy back the June 5 puts for 5 cents, spending a total of $50 – while selling the September 5 puts for a total of $200. This would actually give the investor a profit of $100, when considering the $50 initially spent on the puts but not counting commissions. This small profit would be more than enough to cover the round-trip commissions from any discount brokerage. In this situation, even though we were wrong about a Hecla decline, no money was actually lost!
Conversely, the investor could also opt to buy back the June 5 puts, and hold onto the September 5 puts in the hope that Hecla declined once again – making the puts worth more.
Hecla at $6
With Hecla at $6 in mid-May, and volatility levels the same as today, the June 5 puts would be valued at 10 cents, while the September 5 put would be worth about 40 cents, according to our options pricing calculator. An investor looking to exit the trade would spend $100 buying back the June puts, and make $400 selling the September puts. Even after the $50 in principal spent to leg into the trade, the investor would have captured a profit of $250, less commissions.
As detailed above, the investor could also buy back the June 5 puts he was short, while letting the September 5 puts ride.
Hecla at $5
With Hecla at $5 in mid-May, and volatility levels the same as today, the June 5 puts would be valued at 35 cents, while the September 5 puts would be worth about 70 cents, according to our options pricing calculator. Closing out the trade would net a nearly riskless profit of $300, less commissions.
June Expiration Day
In any of the above examples, of course, an investor could keep their spread open – and let the trade ride until the June expiration. Let’s take a look at how our options would be priced on June 16, options expiration day.
Hecla Trading Above $5
Unless Hecla’s stock remains well above $5, you probably wouldn't wait until expiration day to resolve your spread. But, if this is the case, there's no need for to buy back the calls – the investor could simply allow them to expire worthless.
The only danger, however, would be if Hecla’s stock shot suddenly below $5 at the end of the day. As we know, selling 10 June 5 puts means that you have sold someone else the right to sell you 1,000 shares of Hecla at $5. If the person to whom these options were sold decided to exercise the puts, you’d have to purchase 1,000 shares of Hecla at $5. If the stock is trading at $4.80, for example, an investor would be in the hole by $200.
While this could be easily resolved by selling the stock on the following Monday morning, it's a hassle that we probably wouldn't want to deal with. If this looks at all likely, investors would do well to buy back the options for 5 cents per contract (for a total expense of $50) and save themselves this problem. The investor would still own the September 5 puts almost free and clear - having now paid a total of $100 ($50 initial commitment, $50 to buy back the June puts) plus commissions - and could decide when to sell out of these on their own time.
The ideal, profit-maximizing situation would be for Hecla to expire just above $5 - at $5.05, say. This would mean that the June 5 puts would expire worthless (so the investor wouldn't have to buy them back), but the September 5 puts would trade for 60 cents, giving the investor a clear profit of $550 (minus the initial $50 spent). At this point, the investor could either sell out of the options, or press their luck and hold on.
Hecla Trading Below $5
If Hecla’s below $5 on expiration day, the investor would have to buy back the June 5 puts (unless they wanted hold 1,000 shares of stock!) and could simultaneously sell the September calls to lock in a profit. For example, if Hecla was trading at $4.50, the investor would have to buy back the June 5 puts for 50 cents each (or $500 total), but could sell the September 5 puts for 90 cents each ($900 total), locking in a total profit of $350 (counting the initial $50 spent), less commissions.
The Potential Problem
As we mentioned in our last options strategy article, if it were this simple, everyone would be doing it! The biggest problem with put spreads is that they aren't always this easy to work into. If an investor purchases the September 5 puts, but then Hecla doesn't decline enough in the near-term, the investor wouldn't be able to sell the June 5 puts for a high enough price to cover the bulk of their initial investment. Depending on what happens with the underlying stock, the investor could try to sell the June puts for a lower price (covering less of his initial investment).
If Hecla stays flat or rises further, the investor might not be able to sell the June 5 puts for any appreciable amount. The investor could either remain speculatively short Hecla via the September puts or exit the trade at a loss. However, assuming the September puts are purchased for 35 cents, the maximum loss on the trade would be $350, plus commissions.
Conclusion
For investors recognizing the near-term over-valuation of silver and silver stocks, the trading of cheap options can provide the means to secure nice profits without minimal risk. Investors who aren't familiar with options trading are encouraged to do their homework before attempting these trades.