Three Ways to Play the Silver Rally - While Limiting Your Risks with Options

With the global economy struggling to sustain even a modest recovery, the U.S. Federal Reserve pledging further quantitative easing if needed, and the dollar and several other leading currencies showing unrelenting weakness, there have been plenty of reasons for precious metals to rally of late - and gold and silver have done just that.

Gold has set a series of all-time record highs over the past five weeks, topping $1,350 an ounce for the first time ever as the dollar slipped to its lowest level since early January. Silver, while still well short of the $50-plus-per-ounce record it set when the Hunt brothers tried to corner the market in 1979, spiked to its highest price in 30 years and almost five times the sub-$5.00 levels it traded at from late 2000 to 2003.

The combination of bullish fundamentals, strong technical patterns and the persistent price advance has pushed coverage of gold and silver from the pages of specialty metals newsletters and Web sites to headline status in the mainstream media, stoking soaring investor interest in the process.

And, according to most analysts, the continuing bullish outlook is warranted. Morgan Stanley (NYSE: MS) issued a new report predicting 2011 gold prices could average anywhere from $1,315 an ounce to $1,512 an ounce.

A number of other sources have forecast gold prices reaching $2,000 to $2,500 in the next few years, and a few - including Money Morning Contributing Editor Martin O. Hutchinson - have made a recent case for the yellow metal skyrocketing to as much as $5,000 an ounce.

Silver backers have been equally positive, if somewhat more conservative price-wise. "The medium-term outlook for silver remains positive ... and we therefore raise our medium-term price target to $25 an ounce," said Bank of America Merrill Lynch metals strategist Michael Widmer.

However, David Morgan, one of America's most respected silver analysts, warns that the metal's recent price surge begs for some caution on the part of those just entering the market.

"I've been bullish on silver for a long time and I remain solidly bullish over the longer term," says Morgan, founder of and publisher of The Morgan Report, "However, the market has been rising steadily for more than two months (since a brief dip to $17.40 on July 28) and it is significantly overbought at current levels."

Morgan notes that there are a lot of professional traders - as well as numerous regular investors who got in early - sitting on some massive profits just waiting for the optimum time to cash in. [Note: The standard Comex silver future represents 5,000 ounces, meaning the December contract's move from the late July lows to a recent close of $23.18 would be worth more than $28,000.]

"If they sell, their inclination will likely be to turn right around and go short, which could trap some of the late-comers into bailing out as well, sparking at least a moderate short-term correction," says Morgan.

How big a correction?

Morgan's best guess, based on his current overbought assessment, is at least 10% - which would carry the December futures price back to $20.90 or so.

In spite of that possibility, Morgan still believes investors who don't yet have a silver position should take the plunge - largely because of the increasingly bullish fundamentals, the upcoming period of highest demand for precious metals (due to Asian buying for cultural reasons and Western jewelry purchases for holiday gifting) and the fact that silver has historically lagged gold in rallies, then made up the difference with large late-stage advances.

The latter factor can be somewhat measured by the silver-to-gold ratio - the number of ounces of silver it takes to buy one ounce of gold. At the height of the financial crisis in late 2008, that ratio soared to a whopping 75:1, then lingered in the 68:1 to 72:1 range until August of this year. The recent silver price spike dropped the ratio to just over 58:1, but it still has a long way to go to reach what was considered "normal" in the past - around 35:1 prior to 1980, with monetary norms as low as 16:1 earlier in the 20th century.

According to some calculations, silver would need to rally another $5 to $7 an ounce just to "catch up" with the gains already recorded by gold - and even more should gold continue to rise. To be precise, if gold rises to $1,500 an ounce in 2011 (as Morgan Stanley estimates), and the silver-to-gold ratio drops to 50:1, silver would have to climb to $30 an ounce.

Three Ways to Play the Silver Rally

So, how do you play the potential continuation of silver's rally - without taking on the excess risk carried by outright futures purchases (where a 10% correction could cost $11,500 per contract) or dealing with the hassles (storage, insurance, etc.) of holding the actual physical silver in coins or bars?

A far better approach if you're risk averse is to employ a bullish silver "option spread." There are two ways of doing this, which I'll illustrate using the closing option prices from Wednesday, Oct. 6:

Bullish debit spread - This strategy involves buying an at-the-money Comex silver call option and simultaneously selling another silver call with a higher striking price to offset the cost. The play has an absolutely limited level of risk, but it also has a maximum profit, which is achieved at any futures price above the striking price of the call you sell.

For example, with the December silver futures price at $23.18, you might buy the December $23.00 call at 98.4 cents, or $4,920 ($0.984 x 5,000 = $4,920) and simultaneously sell the December $24.00 call at 59.5 cents, or $1,525 ($0.595 x 5,000 = $2,975). The net cost would be $1,945 (plus commission) - and that would also be the maximum loss on the play, which you would incur at any futures price below $23.00 an ounce at the expiration of the options (Nov. 24 this year).

The maximum profit on the play, which you would achieve at any futures price above $24.00 an ounce on the expiration date, would be $3,055 (the dollar value of the difference between the striking prices, or $5,000, minus the $1,945 initial cost = $3,055).

Of course, you wouldn't have to wait until expiration. If silver made a big move earlier, you could close out the spread, taking a large partial profit - and, if you were still bullish, perhaps initiating a new spread using calls with higher striking prices or a more distant expiration.

Sterling Silver
As an example, the 65.6-cent jump in the December silver futures on Tuesday and Wednesday (Oct. 5-6) would have given the holder of $22.00-$23.00 spread opened Monday at a debit of 38.4 cents ($1,920) a quick profit of 19.5 cents, or $975 ($0.195 x 5,000 = $975) - a two-day gain of more than 50%.

And, if you were willing to risk slightly more in exchange for a larger potential profit, you could buy and sell calls with striking prices further apart - say $23.00 and $24.50. (At Oct. 6 prices, that combo would have given you a cost of $2,645 and a maximum profit of $4,855 at any futures price above $24.50)

Bullish credit spread - This strategy is quite similar to the debit spread, but it uses silver put options rather than calls. To initiate it, you would sell an in-the-money December put option (i.e., one with a striking price higher than the futures price) and simultaneously buy a put with a lower striking price in order to limit your risk. The excess money you receive for the call you sell is your maximum profit, which you achieve if the silver futures price rises and both puts expire worthless.

For example, with the December silver future at $23.18 (again using Oct. 6 prices), you might sell the December $24.00 put for $1.552, or $7,760 ($1.552 x 5,000 = $7,760) and simultaneously buy the $23.00 put for 94.1 cents, or $4,705 ($0.941 x 5,000 = $4,705). You receive a net credit on the two trades of $3,055 (less commission) - and that would also be the maximum profit on the play, which you would achieve should the future wind up at any price above $24.00 on expiration day. The maximum loss would be $1,945 ($5,000 - $3,055 = $1,945), which you'd suffer at any futures price below $23.00.

Obviously, the maximum profit and loss will vary depending on the striking prices you choose, and you can again adjust both by widening the spread between striking prices. You can also take an early profit if silver makes a big move, just as with the debit spread.

A third reduced-risk alternative is to use options on a surrogate for silver or silver futures - an example being the iShares Silver Trust Fund (NYSE: SLV), recent price: $22.70. This exchange-traded fund (ETF) seeks to track the price of silver itself rather than silver futures and does so by holding the actual metal. It also has the most actively traded set of options of any of the current silver-linked ETFs, with each option giving you the right to buy (or sell) 100 units of the underlying trust. As such, you can easily adjust the number of outright call purchases to meet your specific risk parameters.

For example, using the closing option prices for Oct. 6, as above, you could buy 10 SLV November $22.00 calls (which expire Nov. 19, versus Nov. 24 for the options on December futures) at a premium of $1.31, or $131 per call ($1.31 x 100 = $131), or $1,310 for the full position. This would be your maximum risk on the play, while your potential profit, which would start building at an SLV price of $23.31 (the $22.00 striking price, plus the $1.31 premium paid), would be unlimited.

If, for instance, silver prices rose to $26 an ounce at expiration and SLV tracked them perfectly, the price of the $22.00 call would rise to $4.00 ($400 per contract), giving you a profit of $2,690 ($4,000 - $1,310 = $2,690) on the full 10-option position.

The SLV options can also be used to structure either debit or credit spreads, as with the options on futures, with the smaller unit sizes giving you maximum flexibility with respect to choosing the number of contracts, striking prices and desired risk/reward levels.

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