Revisiting March Silver Exit Decision, And Generating Yield With Puts On Gold

by: Richard Shaw

On March 17, we published a short article saying that we exited silver (NYSEARCA:SLV) in favor of our allocation to gold (NYSEARCA:GLD), because the ratio of the price of silver to gold had gone outside of 20-year parameters and was also somewhat parabolic, which is typically a harbinger of a correction.

The comment stream was long, and generally rather upset that we would speak such blasphemous words in the church of precious metals. We actually got violently angry emails as well. Nonetheless, we stick to the simple principle that we report and act upon what we see, and not what we or others might wish to be the case.

It turns out that we were not wrong on this one.

Here is the chart we published in March:

Click to enlarge charts

Here is the same chart updated for today (September 23, 2011):

We are certainly ready to own silver again, but are pleased that our decision to exit worked out.

Given the important industrial uses of silver, in addition to its role as "poor man's gold," silver is not a great bet until the world economy looks up a bit.

We had gold at that time, but it went parabolic somewhat later.

We sold our GLD position on August 23 and 24 at an average price of about $174. That was also a tactical reaction to a parabolic price rise in that security. We felt a bit of seller's remorse a few times afterward, but at $160 today, it worked out so far.

We are believers that your first loss is your best loss, and that applies to stop loss (or protect profits) levels when hit.

Click to enlarge

To keep the cash that came out of gold earning a bit while being available for a new gold commitment, we sold far out-of-the-money November PUTs on GLD with a 124 strike price.

That generated an annualized net premium on the cash exposed to assignment that was about 3%, beating cash in a money market with zero interest.

If the price drops that far (only about a 5% chance of that happening according to options implied volatility), we are happy to own gold again at that price, even if it goes down further for a while. If the price does not drop that far by November 19, we keep the option premium.

We only write PUTs when implied volatility is high and fears are evident, and then only far out-of-the-money, near-term contracts. And we only do that on securities that we would like to own, because taking delivery is always a possibility.

If money markets were paying something, that method might not be so attractive, but when they pay virtually nothing, the annualized premiums on PUTs can be competitive with owning dividend paying stocks and some bonds. You just have to be willing, able and happy to own the stock underlying the PUT if assigned.

We aren't selling PUTs on silver, because we think it has a greater potential than gold to drop to a far out-of-the-money strike price, and then keep going for a while. In that case we would not be so happy to own the metal.

Disclosure: QVM has written far out-of-the-money PUTs on GLD in the company account; and does not have positions in any other mentioned security as of the creation date of this article (September 23, 2011).

Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.