By Mark Bern, CPA CFA
We will apply a strategy that allows an investor to achieve one of three outcomes:
- Achieve an outsized gain from a spike up in silver prices.
- Achieve a very small gain if sliver prices go nowhere.
- Own stock in a great company or ETF at a price that is 30 percent below the current price.
We are going to use Silver Wheaton (SLW) for the first example and then we will provide another example using the iShares Silver Trust Exchange-Traded Fund (SLV) later in the article. We will start with an overview of Silver Wheaton and why we believe this company has an excellent future. Then, we will provide an example of how the strategy works using SLW. And finally, we will provide another example using SLV for those who want a pure play on silver.
The important thing to understand about SLW is its business model. The company does not own mining operations but its revenue is generated through the sales of silver produced at mines all over the world. But before we explain that, let's look at some of the results just to make sure you're paying attention. EPS have grown (from 2006 through 2011) at a compounded annual rate of 33.3 percent from $0.37 per share to $1.56. Sales per share have increased over that same period at a compounded annual rate of 23.5 percent. The company just initiated a dividend payment in 2011 and has doubled it for 2012. I believe that there will be more increases in future years. Total debt equals only two percent of total capital, the payout ratio is only 18 percent and the net profit margin was 75.3 percent in 2011 and likely to remain in the 70-75 percent range after having been expanded from about 54 percent in 2006. I do expect growth to slow somewhat over the next five years compared to the last five, but the business model is likely to generate consistent growth as long as the bottom doesn't fall out of the silver prices.
The business model is ingenious in my opinion. The company locks in rights to buy silver at preset a preset price (usually at about $4 per ounce; average price paid in 2011 was $4.09 per ounce) that is produced by a mine when the mining company is first developing or expanding a mining operation. At this crucial point, the mining company needs cash to develop the mine infrastructure. SLW negotiates with the mining company to provide cash up front in exchange for the right to purchase all, or a significant portion, of the silver produced by the mine. The vast majority of mining operations, whether for copper, gold or other minerals also produce some silver. The silver is not the primary focus of the mining company, so it is of less importance than the primary metal ore being mined. SLW provides infrastructure development capital in exchange for that which the mining company isn't necessarily interested. SLW studies the mineral content from samples at taken from the prospective mine location and determines approximately how much silver will eventually come out before entering any contractual agreements. When operations commence, SLW buys the silver far below the market price and then sells it at current spot prices. That is why the margins are so enormous. The company also buys gold in the same way (average price paid in 2011 was $300 per ounce), but in much smaller quantities. In 2012, total silver equivalent production volume expected to be about 27 million ounces, of which 16,500 ounces will be gold. By 2016, the company projects total silver equivalent production to increase by 65 percent to 43 million ounces, including 35,000 ounces of gold. And remember, SLW has already made the investment up front; it is now simply purchasing the metals at below market prices and turning right around and selling it for a huge profit. Operating costs are minimal. The profits generated are being used to purchase additional future production from new mines. For additional information about SLW please see the company's fact sheet or the annual report, the sources of much of this information and even more detail.
The company had about $800 million in cash and $400 million available on its credit facility for new purchases at the end of 2011. It has increased reserves at a rate of 17 percent per year since inception. As more of its mining contracts begin to produce additional silver and gold, production will continue to increase. Regardless of your expectations for the price of silver or gold, this model makes a lot of sense.
The current price of SLW (all quotes are as of the close on Tuesday, July 03, 2012) is $28.41 per share. What we are going to do is create an artificial buy/write position and pay for it by selling a deep out-of-the-money put option to pay for our position. The artificial buy/write position consists of a bull call spread, which is really much easier to understand than you might think. I'll explain it in detail.
A bull call spread consists of two option contracts; one long call option and one short call option, both with identical expirations but with the long call option having a lower strike price. You will catch on quickly as I walk you through the example.
To begin we sell one SLW January 2014 put option with a strike price of $20 per share and collect the premium of $2.66 per share ($266 for each contract; each contract represents 100 shares). I would really like to own shares of SLW at $20 per share so I am very comfortable with this strike price. In selling the put option I give the buyer the right to sell me shares of SLW for $20 per share and I accept the obligation to purchase those shares, also at the strike price. An option is simply an exchange of a right for a premium and an obligation. The buyer receives the right (in this instance to sell shares) in exchange for paying a premium to the seller who also accepts an obligation (in the case to purchase shares). With a strike price at $20, we will need to keep cash or cash equivalents in our account to secure the put (it becomes a cash-secured put). The amount of much cash depends on what type of account you use for this investment. If you are using a taxable, margin account you may need as little as $600 (30 percent x strike price of $20 x 100 shares) or as much as $1,000 (50 percent) depending upon your broker arrangement. If you are using a tax-deferred account, you will need the full 100 percent, or $2,000 in your account in case the option gets exercised.
Now we have collected $266 and we will use that to purchase the bull call spread which will consist of:
Buying one SLW January 2014 call option with a strike price of $35 for a premium of $4.20 per share ($420)
Selling one SLW January 2014 call option with a strike price of $45 for a premium of $2.06 per share ($206)
The net cost of the bull call spread ($4.20 - $2.06) is $2.14 ($240). That amount is covered by the premium we already collected by selling the put for $266 and leaves us with a net cash gain of $52 for making the trade.
If the stock price of SLW goes up both of our call option premiums will increase and the put option premium will decrease. But the call premiums may not increase as much as the underlying stock does until the option goes in-the-money (in this case, the $35 strike price call that we bought will be in the money when the price of SLW stock hit $35.01). The reason the premium increases will lag the increases in the underlying stock price is because of the time value of the option. But as time passes the time value will decay (decrease) and the closer we get to the expiration date the less a factor will be the time value. One the expiration date, there is not time value at all and the option premiums are priced solely based upon the relationship of the strike price to price of the underlying stock. In other words, if the SLW stock price is $40 at expiration the premiums on the three options will be:
- Long January 2014 $35 call option will have a premium of $5.00 ($40 - $35)
- Short January 2014 $45 call option will expire worthless since the strike price is greater than the stock price.
- Short January 2014 $20 put option will expire worthless since the strike price is less than the stock price.
There are really four possible outcomes for this trade strategy. I listed only three above because those are the obvious and what most questions tend to be centered around. The fourth is simply that, as in the example just above, the price of the stock ends up between the two strike prices of our options. As you can see, calculating the outcomes is accomplished with simple math. The option that is in the money has a value equal to the stock price at expiration less the strike price and the other two option contract expire worthless. Assuming the same outcome as above, that the stock price is $40 our result would be:
- Gain on the long call $500
- Gain on the Premiums paid/collected $ 52
- Total gain on trade $552
- Return in a margin account (50% margin)55.2%
- APR in a margin account (50% margin) 36.8%
- Return in a tax-deferred account 27.6%
- APR in a tax-deferred account 18.4%
The next possible outcome is if the price of SLW is above the $45 strike price of our short call option. I am going to show this one a little differently so you see all the detail. The results would be as follows:
- Value of the spread at expiration $1,000
- Less: cost of the bull call spread premiums -$ 214
- Premium collected on expired put premium$ 266
- Total gain on trade $1,052
- Return in margin account (50%) 105.2%
- APR in margin account (50%) 52.6%
- Return in tax-deferred account 70.1%
- APR in tax-deferred account 35.1%
The next possible outcome occurs when the price of SLW remains below the $35 strike price of our long call but above the $20 strike price of our short put position. All option contracts will expire worthless. Here is how that breaks down.
- Premiums paid for bull call spread-$214
- Premiums collected for selling put $266
- Total gain on trade $ 52
The returns are inconsequential, but the main point here is that you didn't lose money. And now the final possible outcome occurs when the price of SLW falls below the $20 Strike price of the put. Well, you just pay the $2,000 you've been holding in your account to secure the put and hold onto the stock until it goes back up. The 52-week low and high for SLW are $22.94 and $42.50, respectively. The price is currently much closer to its low than its high which is a great time to place a trade like this one. My personal sentiment on SLW is that eventually, regardless of what happens to the price of silver, we are going to see the price rise above that $42.50 level. Silver doesn't need to hit $50 per ounce for that to happen. Remember, production is increasing every year. My 5-year target price for SLW is $60. If I end up buying the stock at $20, I am a happy camper.
Now let's take a look at SLV the silver ETF and see how an example would work with this issue for those who prefer a more pure trade on the price of silver. Here is a definition provided in Yahoo! Finance for SLV:
The investment seeks to reflect the price of silver owned by the trust less the trust's expenses and liabilities. The fund is intended to constitute a simple and cost-effective means of making an investment similar to an investment in silver. Although the fund is not the exact equivalent of an investment in silver, they provide investors with an alternative that allows a level of participation in the silver market through the securities market.
So, when you trade SLV you are looking purely for a price spike in silver to make the strategy work. I just want to be clear on this point. I will not go into as much detail here because it would just seem redundant, but I will show you how to set up the trade and what to expect as a result. SLV is currently priced at $27.49.
The set up:
- Sell one SLV January 2014 put option with a strike price of $20 and collect a premium of $2.43
- Buy one SLV January 2014 bull call spread $30/$40 strikes ($4.10 - $1.76) at a cost of $2.34
- Net of $9 collected from premiums ($2.43 - $2.34) less commissions
- Silver price is at $35 per ounce at expiration yields a gain of $509 (46.3% return on 50% margin)
- Silver jumps to $43 per ounce by expiration yields a gain of 91.7% on 50% margin account
- Silver prices remain stable and all options contracts expire worthless yields a virtual break even
- Silver prices drop below $22 per ounce and you will be obligated to purchase 100 shares of SLV for the strike price of $22 per share. Your eventual outcome is determined by future silver prices.
One thing I would like readers to understand is that there is really no need to hold the positions to expiration if enough of the gain is already available at an earlier time. In other words, if in six to nine months the price of silver goes up to near $40 and you can capture the majority of the eventual maximum profit, why wait? Close all of the positions take your profits and look for a better opportunity. I should also stress that the potential gain from this trade strategy is limited to the spread between the strike prices of the two call options (multiplied by 100 for each spread) plus or minus the net premiums and the cost of commissions.
I hope this has been enlightening to at least some readers. The really big idea is that we really can reduce our risk of loss by using options in an appropriate manner. Our gains may be limited, but the risk/reward ratio is worth it to a conservative investor like me.
As always, I enjoy your comments and will endeavor to answer every question about the article. For those who are new to the writings of K202, there are two authors involved for this contributor: myself, Mark Bern and my associated, Timour Chayipov, the architect of this series. These are not new strategies but Timour has many years of experience in employing them and I hope you will join me in welcoming him to the fold. If you missed our earlier articles using this strategy they can be found by clicking on these links: Apple (AAPL) and Halliburton (HAL). Timour also has another strategy that I suspect you may enjoy written about Procter & Gamble (PG). Be sure to read the comments as the discussion is very much worth the effort.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I plan to employ this strategy with SLW in the next 72 hours.