Seeking Alpha
Portfolio strategy, dividend investing, mega-cap, large-cap
Profile| Send Message|
( followers)  

I recently wrote about one of my favorite topics, volatility and how to trade both the bullish and bearish sides concurrently.

I suppose that if I really thought about it, volatility has long been a favorite of mine as it is at the very core of the ability to create revenue streams from selling covered calls or puts. The more volatile the better, as long as there's some attempt to return to the mean that has meaning for me.

Most people would, justifiably, consider covered call writing to be an essentially conservative and pessimistic strategy. Equally justifiably they would criticize the technique for underperforming during a bull market.

Neither of those assertions have ever concerned me, though, as equally valid is the assertion that the ability to protect your portfolio during a downturn is far more valuable than the opportunity costs of having missed a bull run. Don't believe that? Then just do a little exercise and see what your empirical response is to a very simple question.

Which is more likely to occur? A 20% fall in prices or a 25% rise? In absolute terms, the two are identical, but a 20% drop in prices requires a 25% rise in order to get back to even. It may be the same $20 dollars on every $100, but once investor psychology and emotions take hold, climbing that mountain becomes a bit harder as the most pessimistic of traders take opportunities to cut losses during the climb back and undercut the climb. They help to create the "two steps forward, one step backward" phenomenon.

The fact that I am a conservative investor by nature doesn't preclude the use of potentially volatile and speculative investment vehicles. Despite all of the cautionary warnings regarding leveraged ETFs and, even worse, ETNs that ostensibly have no value, there are many opportunities to use a potential poison as an antidote.

Do you remember the classic book "The Invisible Man," by Ralph Ellison? The secret to the most pure of pure white paints was just a tiny drop of adulterating black paint. Sometimes, it's the counterintuitive thinking that moves you beyond the banal.

In a previous article "When is Speculation Not Speculative?" I focused on a year's experience with ProShares UltraShort Silver ETF (NYSEARCA:ZSL) and only casually made mention of the ProShares UltraSilver ETF (NYSEARCA:AGQ). As their names imply they are both leveraged, while they track silver prices inversely or directly, respectively.

Silver itself, as many will tell you, is a speculative choice within an already speculative category. Forget about your grandfather's day when its movements were very predictably related to that of gold, with a sacrosanct 35:1 ratio. Forget about trying to be its master, as its price movements have confounded the most deep-pocketed and successful investors.

So why would a conservative sort look to silver and to leverage, beyond that? The answer is that within the underlying unpredictability there is safety, thanks to the uber-speculators who seek to further leverage their game play through the purchase of options on the already leveraged products.

While ZSL and AGQ move in opposite directions in response to silver's price action, if their share numbers are balanced against one another -- as there is a large price-per-share differential -- theoretically, on any given day, the loss on one side of the equation is equally offset by a gain on the other position.

Well, at least that meets one of the goals of investing, which is to not lose money. It just leaves the other objective, that of making money out of reach.

But imagine having sold calls on both of those positions. Reflective of their volatility, those option premiums that you, as the seller, receive are quite nice and help form the basis for a very meaningful return on investment.

The key, however, is deciding how to enter into the trade. Ultimately, what entry point you use determines how you subsequently manage the silver-centric portion of your portfolio.

What's necessary is the patience to wait for a large move in one direction or another. Essentially, having an opinion as to direction may be counterproductive, as opinions and biases introduce emotion rather than allowing events to determine appropriate actions. By patience that may mean on any given day, as the market has recently been prone to outsized moves.

Consider the possible entry points following a large decline in silver price, as illustrated in the table below.

Click to enlarge image.

Since you have no existing positions, the only actions available are to either purchase AGQ or sell the AGQ puts.

If you opt to sell puts, you must decide whether to sell "near the money," "in the money" or "out of the money" options. That decision is a personal one and must balance risk and reward, knowing that the greatest premium achieved would derive from selling in the money puts, as long as silver prices recovered sufficiently before the contract expiration date, in return for the greatest risk of assignment. Regardless, you should always choose a strike price at which you would be comfortable owning shares, because sooner or later your contract will be exercised and you will own those shares. Of course, that presents the opportunity of then selling calls on your newly owned shares.

On the other hand, your entry point in response to the decrease in silver prices could simply have been the decision to purchase of AGQ and then selling calls on the long position. Now, if in the course of owning shares of AGQ the price of silver continues to rise, that offers an opportunity to execute a ZSL-centric strategy, even while owning shares of AGQ or short the puts. The choices would be to buy shares of ZSL and sell calls, or to sell puts.

If short the puts and witnessing a rise in silver, an investor can simply close out the position and use the funds to either purchase shares of ZSL or sell calls, again using the same guiding principles as with the original AGQ decision. The precisely opposite approach is taken if silver presents with a price surge and you are ready to enter into the trading cycle.

Due to the liquidity of the AGQ market over ZSL, for both the underlying shares and options, my preference where possible is to initiate on the AGQ side, but I wouldn't sacrifice a good entry opportunity with ZSL if it came along the way. The volatility in the silver market can easily be an intraday phenomenon and offers many opportunities to the investor who has the ability to monitor the movement and the desire to capitalize on those quirky moves in response to the stream of conflicting rumors coming from Europe.

It may not be unusual to find yourself opening and closing a position during the course of the day and perhaps even initiating a new position in the same vehicles and in the same direction as you had when the day started. Keeping track of where you started may prove difficult, but getting lost in realized profits more than offsets getting lost in the history of your trades.

As a potential complication, the ZSL only offers monthly options, whereas AGQ has both weekly and monthly. An additional obstacle is that ZSL recently had a 5-to-1 reverse stock split. As result, some new strike prices -- particularly those that when divided by five yield a strike price in dollars and cents, such as would a post-split strike of $67 -- have very little open interest and have wide bid-ask ranges. I expect that situation will change, possibly from the elimination of some of those strike levels, if necessary.

Now, if I could figure out a similar strategy to deal with the 25-ounce bar of silver that I purchased more than 30 years ago that still hasn't reached its breakeven price, I'd really be a very happy person.

Source: Silver Doesn't Have To Tarnish