Options For Silver And Gold As They Start Their Next Leg Down

Includes: GLD, GLL, SLV, ZSL
by: Scott Gibson

Although most gold bugs and precious metal aficionados are dyed in the wool buy and holders, I would suggest a more profitable alternative. Silver and gold have turned into great intermediate term trading vehicles over the past 12 months. If you have long term positions in either silver or gold, using the Exchange Traded Funds SLV or GLD, that you do not want to sell, you may want to use the following insights to sell covered calls against your positions or hedge your long term holding with inverse funds like GLL for gold or ZSL for silver during down trends.

You can also supercharge the returns on your long term holdings by selling covered put options at the end of downtrends on either silver or gold with the anticipation that SLV or GLD will close above your strike price by options expiration. This allows you to collect the option premium as icing on the cake of your longer term investments during price rallies.

Silver tends to be a lot more volatile than gold and so for those investors who want to invest in precious metals but can't stomach the wild swings that silver goes through then gold is the investment choice for the strategies suggested.

The table below shows how dramatically silver has traded higher and lower in a descending range over the past year.

Silver ended its last move higher on 2/27/11 when its price closed at $35.83. Right now silver and gold are starting their next leg down.

It's clear from both the chart of silver and gold that each are in long term downtrends putting in lower highs and lower lows with each cycle. These downtrends will not be over until we see higher highs and higher lows for both.

The first chart below shows SLV's price movement over the past couple of years with a couple of trend lines to clarify the downtrend silver has been in since its high close of $47.26 on April 28, 2011. Based upon the support levels of the downtrend we can expect SLV to close somewhere south of $25 over the next couple of months.

click to enlarge

The next table shows how similar to SLV that GLD has ranged during the past 7 months as it has trended lower.

Although the moves in gold, as represented by GLD, have not been as dramatic as those in silver, GLD has traced out a similar descending trading range since putting in an all time of $184.59 on 8/22/2011.

The line chart below shows how GLD has traced out lower highs and lower lows similar to the down trend in SLV. Based upon the support levels of the downtrend we can expect GLD to close somewhere south of $1500 over the next couple of months.

Once these new lows are in place then get ready for the next leg up for both.

So how can a long term holder of either silver or gold use this information to increase your returns and/or hedge your positions during down trends? Currently, SLV at the money covered call options with April and May expirations are selling for $1.20 and $1.71, respectively. Slightly more aggressive in the money calls with a $28 strike are selling for $3.25 and $3.64 with the April and May expiration dates. Every call premium that you collect lowers your overall cost basis in the underlying.

For example, let's suppose that you purchased 100 shares of SLV recently for $32.50 and then sold a May at the money covered call on your shares for the $3.25 premium described above. If SLV finishes lower than $31 on options expiration in May you keep the $3.25 and lower your basis in the original 100 shares by 10% to $32.50 - $3.25 = $29.25.

Once SLV trades close to $25 then it would be prudent to re-purchase any outstanding calls you have sold against the position and not sell any additional new covered call positions as $25 is close to the price support line and prices can be expected to rally higher from there.

At this point, aggressive investors may want to sell an at the money covered put option anticipating that the price will rally above support levels and the strike price by options expiration, which will once again allow you to collect option premium. If you are able to collect another $2 in option premium on your long term holdings selling covered puts you reduce your cost basis in the original $32.50 position to $32.50 - $3.25 - $2 = 27.25.

For gold investors, GLD at the money covered call options with April and May expirations are selling for $3.20 and $4.56 respectively, while the more aggressive in the money calls with a $157 strike price are selling for $5 and 6.20, respectively.

Another way to hedge your account during this down trend is by using the inverse funds GLL for GLD and ZSL for SLV. GLL and ZSL are both levered funds and therefore each fund attempts to return twice the inverse price movement of the security its tracking.

The more important issue for long term precious metal holders to recognize is that both gold and silver are in downtrends interrupted by counter trend rallies lasting a month or two before the longer down trend continues. Consequently, you may want to use some of these ideas to hedge your holdings in gold and silver until the longer term down trend reverses itself to the upside.

Disclosure: I am long SLV, GLL, ZSL.

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