Get Set for Another Sustained Run in Silver

Includes: AGQ, SLV, WPM
by: Ananthan Thangavel

Silver has rebounded nicely as of late, rising 13% from May 17 to May 27. The volatility in the market has scared off many participants, but we feel that rebuilding a long position in silver is prudent at current market prices.

Posted below is a chart of silver prices in gray and Managed Money net longs in green.

(Click chart to enlarge)

As can be seen, in the same time period that silver prices have increased 13%, Managed Money net longs have decreased by 12%. This suggests that renewed strength in silver prices is once again due to silver ETF and physical metal buyers. As we have surmised in the past, we believe that ETF and physical ownership of silver is a bullish long-term development. As more and more silver is taken out of world supply by physical silver investors and the ETFs, there is less silver available to satisfy new investment demand as well as industrial demand. As a result of the supply constriction, prices must rise over time.

Also, Managed Money net longs are now at their lowest level since February 2010; silver traded at only $16/ounce then. With the possibility of renewed Managed Money net long interest, prices could and should rise as futures speculators return to the long silver trade.

It's interesting to note that silver prices have not taken an even bigger hit while enduring huge margin increases; such resilience is a testament to the strength of the market. Silver is now one of the least leveraged futures products on the CME. Silver futures require almost 12% of the contract value as margin, which is the 2nd highest (sugar is the highest) margin requirement of the 16 commodities we track. By comparison, gold requires only about 4.5% of the contract value as margin.

While increased volatility in the market is here to stay, we believe that scaling into a long silver position is attractive at current prices.

Trade Recommendation

We recommend utilizing the volatility surrounding silver to sell options on SLW. As we have stated many times in the past, SLW is our favorite commodity-linked equity for the reasons of its purity of leveraged play on silver prices as well as lack of execution risk. The company pays various producers around $4/ounce for silver, but does not actually mine any silver itself. Thus, earnings increase by multiples when the price of silver increases, but the risk of the company not executing on a mine is absent.

We recommend buying SLW stock and simultaneously selling the July 40 call as well as the July 33 put. With the stock at $36.49, the 40 call can be sold for 1.07 and the 33 put can be sold for 1.02. Such a trade would render the effective position as long 100 shares of SLW stock at a price of $34.4.

The trade is profitable as long as SLW stock trades above $34.4 upon expiration. If the stock does not move at all between now and July 15, the return on the trade would be 6%. If the stock is above 40, the return on the trade would be 16.3%. On a time span of 1.5 months, these rates of return are quite attractive.

The risk of this trade lies in the case where SLW trades below $30. In that scenario, the investor would be forced to buy more SLW stock at $33, while still retaining the shares purchased originally. However, we view this risk as minimal given a long-term perspective, as $33 will prove to be a highly attractive entry point on a stock we believe could be easily worth $50 to $60 at some point over the next 1-2 years.

Disclosure: I am long SLW.