There has been a lot of interest in Silver lately. Silver has been touted as a safe haven in a fashion similar to Gold. Many commentators suggest a 5% to 10% or more allocation towards precious metals as portfolio hedges. Quite frankly, I can’t see investing in Silver (or Gold) just a way to hedge a portfolio. Is 5% to 10% really going to make a difference? Investing enough to actually protect a portfolio would distort diversification. There are many ways to hedge a portfolio that don’t run this risk and I have outlined some in previous articles.
So, does this mean that there is no place for Silver in a portfolio? Certainly not. I think it should be viewed in the same light as any other investment. That is, not as a hedge-- but for gain. The view can be taken that Silver is in a bubble, and one can try to make gains as it falls, or Silver can be viewed as an asset that will increase and look for gains on the upside.
I take a slightly different view. Commodities like Silver don’t have dividends, earnings, balance sheets, etc. They are driven more by emotion than demand. As a result, there is a great deal of uncertainty in these types of investments. Whether I take a bull or bear bias, I look to hedge any position in Silver.
I imagine this puts me in the minority. I look to hedge Silver rather than use it to hedge everything else. Keep in mind that whenever a hedge is employed, the objective is to limit downside risk. The offset to this is less upside. Hedging is about “not being killed” rather than “making a killing”. This article will look at Silver from both perspectives: 1) a hedged long bias and 2) a hedged short bias. It is up to the reader to determine which best fits their own assessment at any particular time.
There are several ETFs that provide direct investment in Silve,r and the first step is to pick which is the best fit. Leveraged long or short ETFs, such as AGQ or ZSL, can be immediately ruled out. They are short term trading vehicles and not suitable for my strategies. That leaves three main contenders, SLV, SIVR and DBS. On the surface these seem very similar in composition. However, when using options in a strategy, it is essential to look at the characteristics of the options. In this regard, SLV is the hands down winner for the following reasons:
- SLV has weekly options, which provides more flexibility;
- SLV is more liquid with extraordinarily more shares traded;
- The bid/ask spread is much “tighter”. For example, the January 2012 at-the-money options for SLV has a bid/ask spread of about 1%. The SIVR is closer to 20% and DBS is around 15%.
Let’s look at a hedged long bias strategy. It has several legs:
1. Leg One: Buy a long dated protective put. This is the main component of the hedge. The strike should be near the money. SLV is trading at $31.40, so I’ll go for the January 2013 strike at $31. This costs $ 6.00.
2. Leg Two: Sell a long dated out-of-the money put. This will convert the leg one put to a “bear put spread”. I want this strike to be as far out-of-the-money as reasonable, while still generating meaningful premium credit. The January 2013 strike at $21 is approximately 30% out-of-the-money. It sells for a credit of $1.76. This is about 30% of the leg one premium. Both metrics seem reasonable.
3. Summary of leg one and two: The “bear put spread” protects from $31 down to $21 with a net debit of $4.24.
4. There are 62 weeks to the January 2013 expiry. The average cost of the “bear spread” is only about 7 cents a week ($4.24 divided by 62).
The next objective is really two-fold. First is taking a long position in SLV, and second is to recover the 7 cent weekly cost of the “bear spread”. I can’t do both by buying SLV alone, but I can do both by selling a covered call on SLV. This leads to the last leg:
5. Buy SLV and sell a covered call with a credit of 7 cents. The November 25th call with a strike of $34 sells for 6 cents. This doesn't quite meet the objective. I could sell the $33 strike for 11 cents, but since this is a bull strategy, I'll go with the greater gain possibility and sell the $34 strike.
So where does this all leave me?
If SLV moves up, the long position will capture the move but the “bear spread” will lose about 20% of the move (this number can be found by subtracting the delta of the two strikes on the bear spread). Therefore, the net is approximately 80% of the direct move. A move to $34 will represent an 8% direct move and this strategy will only earn 6%. This is the price of hedging. But, it is only the first week. Each week that SLV moves up, the continued calls being sold generating the 7 cents will eventually mount up.
If SLV moves over $34 the first week, the call wipes out any continued gains, but the “bear spread” will still lose (though at a rate much slower than 20%). This is the real problem with this type of hedge. If this happens, the shares could be “called away”. I can always close the call prior to assignment and institute another call for next week. If I continue with a “bull bias”, I simply continue selling the next call for 7 cents. If I think a pull-back is in order, the strike price could be set lower, even in-the-money.
If SLV drops, I gain the 6 cents on the call. If SLV continues to drop, the put spread comes into play limiting my losses. If I was looking for a bounce-back up, it may be wise to look for less than 7 cents on the covered call, or forego it entirely. One or two weeks will not make much of a difference in the overall picture, but if I was a “bull” at SLV = $31, I am probably still a “bull” at $28. An interesting component of this strategy is that whatever way SLV moves, I can adjust my weekly strike on the covered call to reflect any new bias. Far out-of-the-money for a bullish bias; and near or in-the-money for a bearish bias.
Now let’s look at a hedged bear bias strategy.
It also has several legs:
1. Buy a long dated call. This should be near, but slightly out-of-the-money. The January $32 call fits this and will cost $6.10.
2. It is 14 months to January 2013. Divide the $6.10 by the 14 months and the average cost per month is 44 cents. The reason I’m using months in this strategy instead of weekly has to do with my next leg. I will be selling in-the-money calls. If I did that each week, I’d incur closing costs each week SLV remained in-the-money. By selling monthly calls, I reduce the number of transactions and the costs.
3. Sell in-the-money calls at a strike designed to generate 44 cents per month in extrinsic value. The December $28 strike generates a credit of $3.90. This is 50 cents extrinsic ($28 plus $3.90 minus $31.40). Note that in this case, I’m not converting this to a spread as I did in the previous example. This is for two reasons. First, I think that SLV is likely up in the longer term and the “bear bias” is shorter term. Second, it just illustrates another method or strategy.
Where does this leave us?
If SLV goes down, the short call gains dollar for dollar down to $28 (a 12% move). But, the long dated call loses about 50 cents for each dollar down. So, the net gain is only about 50% of the actual move.
This is much less than the 80% of the previous example, as I decided not to sell a long dated call and create a “spread”. I was preparing for a drop, but decided that longer term I was bullish. This is reflected in the result. I may now either continue to sell in-the-money calls for 44 cents extrinsic or prepare for a bounce and actually sell out-of-the-money calls for the extrinsic. My choice.
If SLV goes up, I lose dollar for dollar on the short call, but the long call gains about 60 percent of the move. So my loss is only about 40% of the move. This is the advantage of the hedge. Though I have initial losses, I continue to wait for the drop. If this never comes to pass, the continued selling of calls for an extrinsic of 44 cents will eventually close this gap to near zero. If I was bearish before an up move, I’m likely more bearish after the move. Therefore, I will continue selling the next month’s call but may go for less extrinsic value and sell it deeper in-the-money.
As with the previous strategy, I can adjust the strikes at each expiry as I think market conditions dictate.
In conclusion: Here are two strategies that represent hedged plays on SLV. One has a long bias and one a short bias. Each strategy has the flexibility to adjust to the other bias as warranted. Neither strategy will gain as much as a direct play on SLV, but neither strategy risks as much either.