2 Bearish Bets on Silver Might Not Be So Bearish

Apr.15.11 | About: iShares Silver (SLV)

Bloomberg reported that a trader put an “almost $1 million bet” that the iShares Silver ETF (NYSEARCA:SLV) would decline by July.

On Monday April 11, with SLV closing at 39.21, a trader bought 100,000 July 25 put options on SLV at a cost of about 10 cents each ($10 per contract or about $1 million in total).

The open interest in that option was only about 6,000 contracts, so that transaction represented a pretty significant trade.

Then on April 12, another Bloomberg article noted:

Trading of bearish options on an exchange-traded fund tracking silver jumped to 3.7 times the four-week average, boosted by a single trade for a second day, as futures on the metal snapped a seven-day winning streak.

Evidently another trader (or maybe the same one) put about $770,000 into a more complex options spread that benefits if SLV falls.

So should SLV longs be worried? I doubt it. Let’s take these trades one at a time.

Taking a Cheap Shot

In my view the first trade, the purchase of the July 25 puts, is simply a cheap shot. SLV does not have to plummet for this trade to work out. Assuming constant volatility (and you can’t always assume that of course), this is an approximate view of the theoretical payout:

Click to enlarge

Click to enlarge

Bloomberg quoted Henry Schwartz, president of Trade Alert LLC: “It’s so far out of the money that the buyer is probably just looking for a moderate pullback because a $3 retracement to where it was in March could double the position to $2 million.”

That’s true, but as the chart shows, such a move would have to happen in the next couple of weeks or so. Otherwise it would take a larger drop in SLV for the trade to be profitable. That’s because the time decay for these options will start eating into potential gains more rapidly as the weeks go by.

So I consider this a “cheap shot.” Maybe the trader is thinking of closing the position with even a 50% profit, say about $500,000. It wouldn’t take a huge move to make that kind of profit if SLV fell by only about 10% in the next week or so. I’m long SLV, but I don’t consider a temporary correction out of the realm of possibility.

I do note that as of the Thursday, April 14, close, even though SLV ran up even higher, those puts were bid at 13 cents – three cents higher than Monday. That’s probably something the traders who sold those puts for only about 10 cents each didn’t expect.

A Butterfly Spread: Betting on a Specific Level

The second trade is a bit more complicated. Evidently a trader sold 50,000 May 36 SLV puts – and at the same time purchased 25,000 May 34 puts and 25,000 May 38 puts. The net cost was about 31 cents – or about $770,000.

You might recognize this as a butterfly spread. This is a strategy that benefits if SLV declines to the 36 level, but not much further. According to Bloomberg, “the trade cost 31 cents per contract and may be worth up to $1.69 if the shares are at $36 at expiration on May 20.”

Yes that’s true. And that $1.69 could mean the trade would be worth about $4 million, but that’s if SLV closes at exactly 36 on May 20. How likely is that?

This chart shows the theoretical profit or loss for this trade. The trader has limited risk, but note how the window of profitability grows ever more narrow as time goes by. And the larger your profit target, the longer you have to hold the position.

Click to enlarge

Click to enlarge

Everyone has their “bread and butter” trades, and many like butterfly spreads. But anyone who successfully trades them has to have the talent for knowing where a stock or ETF will trade and, more importantly, when. (I’m not that talented by the way.)

Plus this could be also be a hedge. Perhaps someone who’s long wants to take some of their profits to bet on a temporary a drop to the 35 to 37 level in the next few weeks. It could happen. After all, it’s only been a few weeks since SLV decisively crossed the 35 level.

So yes, while these are technically “bearish” bets, I don’t consider them all that bearish.

Disclosure: I am long SLV.