For the month of April, silver rallied an incredible 28.7%. While we love precious metal fundamentals on a long-term basis, one doesn’t have to be an expert to realize that 30% monthly returns are unsustainable. Due to the stratospheric rise of silver, the CME has raised margin requirements on silver repeatedly. As of this writing, the CME raised margin requirements on silver for the second time in a week, and silver futures are trading down 8.5%.
As we surmised in our intra-week trading recommendation, silver was due for a correction. Its divergence from the moving averages, as well as the extreme volatility in its moves as of late, were ripe indications of a deep correction.
However, we remain bullish on silver going forward, and we view this correction as an eventual buying opportunity. Due to silver’s recent extreme volatility, options on silver and silver-related investments are expensive, making our preferred strategy of selling options highly attractive.
Shown below is a chart of SLW versus silver futures normalized for percentage.
[Click to enlarge]
As can be seen, after outperforming silver for most of the past year, SLW has been underperforming silver. As a silver royalty trust with an average cash cost of around $4 per ounce, one would expect SLW to outperform silver itself. However, recent fears about Peruvian mine nationalization have caused severe harm to SLW’s share price even as silver itself has rocketed higher.
Even though knowledge of Peru’s nationalization plans is admittedly sketchy at best, SLW’s business is not dependent on Peru at all. Just 2.5% of SLW’s proven silver reserves lie in Peru, and Peru’s contribution to 2011 forecasted production is so low that it is not even separately reported. Peru’s contribution to SLW’s production is contained within a category labeled “Other,” which will comprise 17% of production in 2011. The “Other” category is split between 12 mines, of which three are located in Peru.
It is our belief that the Peruvian situation will not prove meaningful to SLW’s business regardless of how it plays out, and that the underperformance in SLW’s shares will not persist. Furthermore, a correction in silver prices will lead to further correction for SLW and increased volatility, which makes selling put options a good strategy.
We recommend selling the January 2012 35 puts on SLW. On Friday, these puts sold for $4.40, although with Monday’s likely selloff, these puts could be sold for considerably more. At a projected earnings of about $2 per share in 2011, an entry price of $35 on SLW would be a steal for such a high margin and high growth company (would be entering at a 17.5 P/E). Investors would be profitable in such a trade as long as SLW is trading above $30.60 in January 2012. As silver could continue to correct considerably longer to the downside, an investor would be wise to scale into this trade by selling a few contracts at a time until the desired full position size is reached.
An interesting hedge as well as compelling trade would be to sell call options on the double-long silver ETF, AGQ
. Since AGQ is meant to perform twice as much as the daily performance of silver, AGQ is extremely volatile, and options on it are ridiculously expensive. On Friday, with AGQ shares trading at $358, the May 500 calls could be sold for $5.10. This trade would be profitable as long as AGQ is not above $505.10 in three weeks (an incredible 40% higher). Since the trade is on the double-long ETF, this would mean that the investor is betting silver will not increase a further 20% inside of three weeks.
Furthermore, due to the momentum nature of leveraged ETFs, silver would not only have to rally 20% for an investor to experience losses, it would have to do so in a straight line. Because leveraged ETFs rebalance at the end of each day, if silver were to experience any “chop” along its rise (up two days, down one day, etc.), AGQ would not perform well. We view the sale of call options against AGQ as a highly attractive trade to hedge existing long precious metals exposure, as well as an outright speculation that silver cannot continue in a straight line upwards.
Disclosure: I am long SLW, short SLW puts, short AGQ calls.
Additional disclosure: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.