Silver Options: How to Protect Your White Metal Profits

Turn on the television or flip through the pages of any major newspaper, and the top stories will be either the stock market's unrelenting rise in recent days or gold's climb to yet another record high.

Without question, both are worthy of note - but the real star over the past eight months has been silver.

Stocks, gold and silver all hit cyclical lows during the final week of August 2010. The Dow Jones Industrial Average bottomed on Aug. 26, closing at 9,985.81, while June Comex gold futures closed at $1,223.30 an ounce on Aug. 24, and July Comex silver contracts settled at $18.121 per ounce on Aug. 23.

Since then, the Dow has climbed to 12,263.58, a gain of 22.80%. And June Comex gold contracts on April 8 reached a record high $1,474.10 an ounce - a gain of $250.80, or 20.50%.

Those are great returns - but silver puts both to shame. The "poor man's precious metal" - as measured by the July Comex future - skyrocketed to $40.637 an ounce through April 8, a gain of $22.516, or 123.25%. (That run continued early this week, with silver reaching its highest level in 31 years.)

Since each full-sized Comex future represents 5,000 ounces of silver, this run-up in the price of silver means a single contract is now worth $203,185 ($40.637 x 5,000 = $203,185). More importantly, it also means that anyone who bought a silver future at or near the August 2010 lows is now sitting on a profit of roughly $112,580 ($22.516 x 5,000 = $112,580).

Even those who got in later - perhaps buying in January after silver broke short-term support near $30 an ounce and pulled back to $27.946 before resuming its climb - would be sitting on profits of $12.50 per ounce or so, worth around $62,500 per 5,000-ounce contract.

The question now, of course, is what happens next?

Many analysts believe silver's rally still has a good way to go, based on three key factors:

• Unlike gold, which now stands more than $600 an ounce higher than the record high of $850 it set in the 1979-80 metals rally, silver is still almost $10 an ounce below the record intraday high futures price of $50.35 an ounce it set in January 1980.
• The ratio of gold to silver prices stands at roughly 36-to-1, below the 47-to-1 average for all of the 20th century, but still well above the historical norm and substantially higher than the ratio of 16.8-to-1 set at the 1980 highs.
• Silver has many more everyday uses than gold - in everything from computer components to photo processing - and is thus subject to relatively high industrial demand over and above its investment value.

On the other hand, it's extremely difficult to look at an advance like the one we've seen since August (or even January) and not expect some kind of near-term retracement or correction - especially if you're sitting on paper profits of $30,000, $60,000, or even $110,000 on a single futures contract position.

So, if that's your concern right now, what do you do? How do you reduce the risk of giving back your gains without simply selling and forgoing your chances for more profits should silver continue to rise?

Put Option Protection

Actually, there are several ways you can hedge against losing your silver gains - depending on the vehicle you used to make them in the first place, and how much you're willing to pay to protect your profits.

First, you can "insure" your gains by purchasing a protective put option for each silver futures contract you hold. This is the classic hedging strategy, and also the simplest for those who hold either futures contracts or large quantities of physical silver. However, it's also fairly expensive because the recent big moves by silver have driven up premiums on options on silver futures.

For those who don't know, a put option gives its owner the right to sell a specific underlying asset at a designated price for a limited period of time. For example, a June Silver Wheaton Corp. (NYSE: SLW) put option with a strike price of 47 would give its holder the right to sell 100 shares of the silver mining company's common stock at a price of $47 per share at any time between the date of purchase and the option's stated expiration date - in this case, June 17, 2011.

(Note: A call option, the other basic type of option, gives its holder the right to buy a given asset at a specified price for a limited period of time.)

With respect to silver futures, one July Comex silver put option would give its holder the right to sell one July Comex silver futures contract (controlling 5,000 ounces of physical silver) traded on the Comex division of the Chicago-based CME Group (Nasdaq: CME).

The best way to explain exactly how this strategy works is with an example, so let's assume you bought a July Comex silver futures contract in late January, paying a price of $28.00 an ounce (making the full 5,000-ounce contract worth $140,000).

Silver turned upward soon after, climbing steadily to its Friday, April 8, closing price of $40.637 an ounce - meaning your 5,000-ounce futures contract had risen in value to $203,185, giving you a paper profit of $63,185.

Given the three factors cited above, you think silver will most likely keep climbing - but you're also concerned that silver could experience at least a modest price correction before the July future comes due for delivery, forcing you to cash in. What do you do?

That's a little more expensive than the at-the-money $41.00 put you might first be inclined to use for this play, but it locks in a larger percentage of your profits, making it a good protective investment. Here's why:

• If silver corrects, you guarantee that you will give back no more than $9,835 of your existing profit of $63,185 - no matter how far prices fall. Even if silver plummets to, say, $30.00 an ounce, the most you will lose is $9,835. That's compared to a horrifying $53,185 loss you'd suffer if you held only the futures contract, stubbornly hoping for a rebound.
• If silver's advance continues, you'll keep adding to your profits once the futures price moves above $43.967 (the current silver price plus the cost of your insuring option). For example, should the July silver future rise to $50.350, the 1980 high, it would be worth $251,750, and your added profit on the hedged position would be $31,915 versus the extra $48,565 you would have made holding the futures contract alone. That may seem like a sizable difference - but it pales beside the loss it will save you if silver falls instead of continuing to rise.

To clearly illustrate, the accompanying table shows the possible outcomes for this particular example at a range of silver futures prices from $30.00 to $60.00 an ounce (the top line of the table shows the opening values for the hedge position).

Again, this is just one example. Pick a put option with a lower strike price - say $40.00 - and the cost of your hedge will be less ($11,085 at April 8 prices), but you'll also get less protection (e.g., you could give back $14,270 in profits with the $40.00 put).

You also could extend the time frame of your hedge by rolling the futures contract to a future delivery month - say, September - and buying the matching put option, which would protect you until it expired on Thursday, Aug. 25, 2011.

[Hedging Tip: An alternate hedging strategy involving options on Comex silver futures - one that can be implemented at little or no cost - is discussed in the recent Money Morning article titled "Tips for Hedging Silver." However, that strategy limits your added profits should silver continue to advance.]

Added Insurance

Remember, you can buy a protective put option to lock in profits on other silver-related assets, too. If you made your gains on silver via mining stocks or a leading silver exchange-traded fund (ETF), the same "insurance" strategy just described will also work for those products, so long as they have related options.

As an example, the shares of Silver Wheaton Corp. (NYSE: SLW) rose from $29.24 in late January to close at $46.91 on April 8. Had you purchased 500 shares back then, you'd be sitting on profits of $8,835 - profits you could lock in until June 17 by purchasing five SLW put options (one for each 100 shares of stock) with a strike price of 47. Those puts were quoted at $4.10 on Friday, or $410 per contract, meaning it would cost you $2,050 to insure your profits against a pullback between now and mid-June.

There are far fewer "pure play" silver-related stocks listed on U.S. exchanges than there are gold miners, but several others that have options include Pan American Silver Corp. (Nasdaq: PAAS), recent price $42.65; Hecla Mining Co. (NYSE: HL), recent price $9.76; Coeur d'Alene Mines Corp. (NYSE: CDE), recent price $36.69; and Silvercorp Metals Inc. (NYSE: SVM), recent price $15.99. Be aware, however, that mining stocks don't always track the prices of the metals they mine, so their option prices might not fully reflect a silver pullback.

If you own smaller quantities of physical silver (or mining stocks without options), you can hedge with put options on an ETF that closely tracks silver prices. The leading U.S.-traded silver ETF (others trade in Canada and Great Britain) is the iShares Silver Trust (NYSE: SLV), recent price $39.86.

It's structured so that its single-share price closely mirrors the price of one ounce of physical silver (less fund management expenses), so it makes a good hedging vehicle for holdings of the actual metal. Just buy one put option - representing 100 ETF shares - for each 100 or fewer ounces of physical silver you hold, and the put's price should rise virtually point for point (less time-value erosion) with any decline in silver.

[Hedging Tip: If you'd rather post a margin deposit than pay premiums for put options, you can also hedge your physical silver holdings by selling short one SLV share for each ounce of silver you own. If silver prices fall, gains on the short ETF position should offset losses on the physical silver. Of course, if silver keeps on climbing, losses on the short ETF would cancel out the gains.]

Inverse ETFs

Buy shares in an "inverse" silver ETF - This is perhaps the easiest way for holders of smaller quantities of silver bullion or coins to hedge their positions and lock in profits - simply because the ETF shares will rise in price as silver prices fall.

The ProShares UltraShort Silver ETF (NYSE: ZSL), recent price $19.65, is structured so that its share price moves in the opposite direction from the price of actual silver. In addition, this fund uses leveraged futures and options positions so its price moves roughly twice as much as the actual silver price (less fund expenses).

Thus, if you hold 200 ounces of silver bullion, you could hedge it by purchasing 100 shares of ZSL. If silver prices then fall, your gains on the ZSL shares should roughly offset the loss in value of your physical silver holdings. Pay attention, though, because the changes are measured on a percentage basis, not a share-to-ounce basis. In other words, if silver rises by 1%, ZSL share prices would fall by 2%.

To give you an idea of how this might work, consider this: On Aug. 23, 2010, when silver (based on the July future) was priced at $18.121 per ounce, ZSL shares closed at $135.20. Since then, July silver has climbed to $40.637 per ounce, while ZSL shares have plunged to just $20.33. Now, if silver keeps rising, ZSL offers a fairly small downside - but if silver corrects sharply, ZSL should skyrocket.

Sometimes, in volatile markets, it's harder to keep profits than it is to earn them. But, if you make appropriate use of options and think outside the box in using ETFs as hedging vehicles, you'll almost certainly fare better than most of the other players in the game.

News and Related Story Links:

• Money Morning:

Tips for Hedging Silver.

• MarketWatch.com:
  Gold Falls on Stronger Dollar; Silver Gains.
• Money Morning:

Hedging Strategies: At a Time of Record Gold Prices,
This Simple Option Play Will Protect Your Profits

• Money Morning Defensive Investing Series:
  Defensive Investing Series Stories
• Money Morning Defensive Investing Series:
  How to Use Stock Options to Insure Your Holdings Against Short-Term Pullbacks
• Money Morning Defensive Investing Series:
  Defensive Investing: A Stock-Option "Insurance Policy" That Can Protect Your Profits
• Money Morning Options Strategies Story:
  Three Ways to Play the Silver Rally - While Limiting Your Risk with Options
• Money Morning Options Strategies Story:
  Investing Strategies: How to Decode the New Options Trading Symbols
• The Options Guide:
  Silver Options Explained
• Investopedia:
  Put option definition
• Investopedia:
  Call option definition
• Investopedia:
  Strike price definition
• Investopedia:
  Underlying security definition
• Investopedia:
  Expiration date definition
• Investopedia:

Margin definition

• Investopedia:
  At-the-money option definition
• Investopedia:
  Out-of-the-money option definition
• Investopedia:
  Option premium definition
• Investopedia:
  Time value definition
• Investopedia:
  Inverse ETF definition
• Investopedia:
  Futures contract definition
• CME Group:
  Official Web site
• CME Group:
  Silver options product calendar
• Chicago Board Options Exchange (CBOE):
  Official Web site
• Yahoo! Finance:
  Options Center Home Page
• Amazon.com:
  "Commodity Options: Spectacular Profits With Limited Risk," by Larry D. Spears