A High Risk/High Reward Play For Silver In 2013

| About: iShares Silver (SLV)

If you have read my earlier articles, you know that I am not a big fan of precious metals. However, there is one exception. In 2013, I am an unabashed fan of silver.

Why is this the case?

I had earlier written an article called All That Glitters Is Not Gold: A Case For Silver. I had tried to explain in that article why I think 2013 will be a good year for silver.

The main reason is that 65% of silver use in for industrial purposes and photography, and only 20% or less is for investment. This makes silver more like a real commodity than a hyped precious metal that has no intrinsic value or practical use and trades purely on sentiment, like gold for example. When industrial growth is back, so is silver. With the worldwide expansion in monetary policy to engineer industrial growth, I believe silver demand will explode in 2013, and with it prices will go up.

In addition, the Central Banks around the world are engaging in a coordinated reflation and consequent accommodative monetary policy. To put it bluntly, they are printing cash like it is going out of style. While I wish them best of luck in their effort to create some inflation and get the world economy out of the deflationary spiral it is in, I am not convinced they will be able to do it easily, and far more cash infusion will be needed than currently planned. (The rationale is detailed in my article Nominal GDP Targeting: Good For Consumer Spending, GDP, The Market, Inflation, And Gold.) Regardless, people will be expecting inflation, and this should give a boost to silver prices as well.

So, how to make money out of this trend?

The simplest way is to invest in silver ETFs. This is how various silver ETFs have done in the last year.

SLV Chart

The bread-and-butter ETF for silver investors is the iShares Silver Trust ETF (NYSEARCA:SLV). It tries to reflect the price of silver. The biggest and the most liquid of all silver ETFs, this is something any silver investor should consider. The ETF has been up about 4% this year, but over the long run it has doubled over the past 5 years as the price of silver has skyrocketed.

Then there are the leveraged ETFs on silver price. As anyone who has read my previous articles know, I am a big fan of leveraged ETFs. Charming financial instruments, these open up all kinds of possibilities because of the unique way they are constructed.

First comes the 2x leveraged ETF pair, the ProShares Ultra Silver ETF (NYSEARCA:AGQ) and the ProShares Ultrashort Silver ETF (NYSEARCA:ZSL). Both of these try to replicate on a daily basis 2x or -2x the performance of the SLV ETF. As the chart shows, AGQ is down about 5% for the year, while ZSL is down about 33%.

Curious, isn't it? While the base ETF is up slightly, the 2x leveraged bull ETF is down instead of up, and the 2x bear ETF is not only down, it is down by much higher than the 10-15% that one would have expected it to drop. This is what makes leveraged bull and bear ETFs such fascinating creatures. they erode value over time with volatility and hence open up several interesting opportunities.

To understand the rationale behind the phenomenon, interested readers should look at my article From Russia With Love: A Big Gain/High Risk Play. I explain there how when the underlying entity stays almost flat, but has a high volatility, leveraged ETFs start to erode fast.

So, if the 2x ETFs are eroding value fast, what about their 3x cousins, the VelocityShares 3x Silver ETN (NASDAQ:USLV) and the VelocityShares 3x Inverse Silver ETN (NASDAQ:DSLV)? Turns out they are down 19% and 49% respectively in 2013, keeping up with the high value erosion expectations bestowed on them. So, how should a silver investor profit from this trend in 2013?

Let's first examine how much value these 3x leveraged ETFs have eroded since inception. The charts below shows that.

USLV Chart

It seems that in only about a year, the 3x leveraged ETFs have managed to wipe out ~50% of value. For someone who shorted them, that's doubling of the money in a year. Unfortunately, it is very hard to short these leveraged ETFs. So, I went to look for put options, and discovered, much to my dismay, that those don't exist as well.

Clearly, the options market makers do not like to lose money. Good for them, but too bad for silver investors.

What about the 2x leveraged ETFs? As the below chart shows, these look very promising.

AGQ Chart

Since inception, AGQ has given somewhat higher returns than SLV. So, while it has eroded value, it has not eroded a whole lot of value. But, investors have hit pay dirt when it comes to ZSL. It is down 99% over 4 years. If an investor could have shorted this since inception, he or she would be up 100x, enough to retire a few times.

Trouble is, ZSL is not very shortable either. Good news, however, is that put options exist on it. The January 14 expiration 50 strike puts on ZSL are trading at $10.60/14.20 (bid/ask). So what is the expected profit of buying these puts? A Monte Carlo simulation is handy.

I assumed that SLV grows by 15% in 2013 and its daily volatility remains unchanged. With that, I created a set of 240 daily returns for SLV, and 240 daily returns for ZSL leveraged at -2x for SLV. At the end of the 240 daily returns, I estimated the price of ZSL and that of the January 2014 strike 50 put on ZSL. I assumed that the cost to buy the put is midway between bid/ask, or $12.40. Over the 5000 Trials, the 95% confidence interval for the expected return of buying this put is 80-87%. In other words, there is a 95% probability that this put returns 80%+ in 2013, if SLV were to return 15%.

What happens if SLV returns more, or less? If SLV returns 10% in 2013, the expected return of the put with 95% probability is 46-52%. If SLV returns 5%, the same as in 2012 which was a rather poor year for SLV, the expected return of the put with 95% probability is 26-33%. I expect SLV to return at least 15% in 2013 based on the rationale above, so I think it is safe to assume that doubling of value with this put is not unreasonable. Of course, you are risking 100% downside as well, as the put may expire worthless. But the simulation shows that the odds of that are miniscule, assuming silver does at least as well in 2013 as it did in 2012.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice. I am merely stating what I personally plan to do for my own portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.