What Do Soaring Call Option Premiums Mean For Gold And Silver?

| About: iShares Silver (SLV)

More evidence that the recent sell-off in precious metals markets was due to speculative traders pushing the price around rather than an end to the long-term bull market comes with word that call option premiums for gold and silver ETFs are now soaring as prices rebound.

After the steepest plunge for precious metals in over 30 years, gold and silver prices are now rising sharply as shown below via Stockcharts, a move that was anticipated by option traders not long after the lows of ten days ago.

The chart doesn't reflect today's $20+ per ounce move higher and, while some of this surge is no doubt due to short-covering, there are clearly a lot of investors in the world who thought that last week's sell-off was way overdone.

Lower prices have resulted in physical demand for gold and silver bars and coins skyrocketing around the world as retail investors clearly don't share the dire views of some investment banks that proclaimed the "gold bubble has popped" and that the "secular bull market is dead."

Metal continues to flow out of gold and silver ETFs such as the SPDR Gold Shares (NYSEARCA:GLD) and, to a lesser degree, the iShares Silver Trust (NYSEARCA:SLV). Lots of analysts seem to be concerned about this, but, as detailed the other day in Good Riddance To The Weak Hands Selling GLD Shares, maybe having this group of U.S. investors exit the market is a good thing.

But, the really interesting thing about these ETFs is the call option trading.

While gold and silver ETF buyers may be getting scarce, buyers of call options for both of these metals have been paying up in a big way over the last week for leveraged exposure to higher prices.

So far, they've been right in doing so as the gold price has jumped about $130 an ounce over the last eight days of trading with little indication of this slowing down.

I've been selling covered calls for shares of both GLD and SLV since 2009 and, about the only time I remember seeing call option premiums this big was back in 2011 when it looked like the silver price was headed to $80 an ounce and, later in the year, gold seemed headed to well above $2,000 an ounce.

Over the years, I've used the near-month call option with a strike price just above the GLD share price as a gauge of investor sentiment.

Based on yesterday's close of $138.37 for GLD, the option contract of interest would be the May $139 call options (GLD130518C00139000) that closed at $2.50 per contract.

That represents a premium of 1.8 percent and this is for a holding period of just over three weeks, rather than the normal four or five-week holding period.

By way of comparison, if you go back to mid-September of 2011 when the gold price was near its record high and GLD shares traded at $176.03, October 2011 $177 call options sold for $5.40 per contract with five weeks of time premium left.

Another example that can be pulled from my old records came a month later in mid-October of 2011 when the gold price was moving lower, but interest was still high. With GLD shares at $159.52, November 2011 $160 call options sold at $4.35 per contract.

Both of these examples represent a one-month return of more than two percent, a historically high premium for one-month GLD call options with a strike price just over the market price.

Fast forward to today and, adjusting the $2.50 premium for May 2013, $139 GLD call options for a longer holding period results in option buyers paying well over $3 per contract.

Clearly, this is not the same sort of enthusiasm that was seen 19 months ago, but it is far higher than anything that would be considered "typical."

Near month GLD option premiums for the strike price just over the market price are normally just a fraction of what we're seeing today in what is a clear sign that option traders think metal prices are headed higher.

So far, they've been right about that and, despite paying up for this leveraged exposure, they've been rewarded.

Disclosure: I am long GLD, SLV. 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.