Sooner or later, every precious-metal investor is confronted with a big problem...
It goes like this:
First, a big bull market in gold and silver – like the one that started in 2001 – enjoys a major run higher. (Think back to when gold shot from US$650 an ounce in July 2007 to $1,000 an ounce in early 2008.)
Second, you get a holiday bonus or a cash windfall of some kind. You'd like to place a portion of this cash into precious metals. But after such a huge run higher, you feel like you've "missed the boat." You're worried you're buying near a peak.
You're facing a problem that can be solved with a little-known technique using the options market... one that allows you to buy gold and silver at discounts of around 10% to 20%. This technique is called "selling puts."
When you sell a put option, you agree to buy an asset at a predetermined price at a predetermined time. Used properly, selling puts is an incredibly powerful tool.
To get an idea of how selling a put option works, let's use an example. Let's agree to buy shares in the major silver fund, Ishares Silver Trust (NYSE: SLV, Stock Forum).
The silver fund trades in lockstep with the actual price of an ounce of silver. Right now, SLV trades for about $18 per share.
Let's say you'd like to own 100 shares of SLV. But you're worried silver is too expensive. You'd like to buy it a little cheaper than its current price. You'd like to pay, say, $17 per ounce for your silver. Here's what you do...
You agree to buy SLV for $17 per share about five months from now. You do that by selling a put option on SLV with a "strike price" of $17 and an expiration date five months down the road. As I write, this option is trading for around $1 (it's a bit less than that, but we'll use $1 to keep the math easy).
The standard size of a contract in the options market is for 100 shares. You want to buy 100 shares, so you sell one option contract. You receive $100 ($1 per option x 100 shares per contract).
This trade can play out in two ways...
1) Silver stays above $17 or continues to rise.
No one will sell their SLV shares to you at $17 if SLV is trading at $19 or $20 per share. If the price of silver continues to rise, you simply pocket the $100 you collected from selling the puts. You can repeat the process and collect another round of income.
Collecting a "free" $100 isn't bad. But we're much more interested in scenario No. 2...
2) Silver falls below $17 over the next five months.
When the time comes for your option contract to expire, your broker will automatically buy 100 shares of SLV for $17, just as you agreed to. (Make sure you have the money to cover this trade ready.) Since you received $1 per share for agreeing to buy SLV for $17, your real cost is $16 per share.
Here's how the math looks...
Either buy SLV today:
100 shares of SLV at $18 per share = -$1,800.
Or buy SLV at a discount in five months:
1 put option contract to buy SLV at $17 in five months = +$100
100 shares of SLV at $17 per share = -$1,700
Real cost of shares: $1,600
Savings: $200
Discount 11.1%
By waiting to buy silver (and selling the put), you are able to save $200 (before transaction costs) and pick up silver for 11.1% less than it cost five months earlier. (Keep in mind: This is just an example. With this size position, transaction costs would eat into your savings.)
If you're looking for even bigger discounts, you can go farther out in the calendar. You'll receive more money for entering into longer contracts. You can get over 20% discounts from current prices.
To become eligible to sell puts, you must contact your broker. He'll initiate paperwork for you. If you are not familiar with options, it's best to spend a good amount of time studying how they work before putting on these sorts of positions.
But if you're worried you've missed out on a big run in precious metals – or any trade for that matter – it's more than worth putting the time in to get a safe, double-digit discount.