When Is Speculation Not Speculative? Taking Profit From Silver ETFs

Includes: AGQ, ZSL
by: George Acs

When is Speculation not SpeculativeBy its very definition, someone who engages in a covered call strategy is not very amenable to risk taking. By that measure, I haven't taken a risk in 4 years, yet I've been pretty happy and certainly not bored, despite the daily grind of predictability.

My investing goal has always been to generate a predictable stream of income in the 2-4% range while maintaining portfolio integrity. That's an unnecessarily fancy way of saying I want to make money without risking any.

That's become a bit more difficult as overall volatility has declined. With volatility came enriched option premiums, even for relatively staid stocks, which were by far the kind that I favored. I'd much rather see my money in Dow Chemical (DOW) than a one time high flyer like Zoltek (NASDAQ:ZOLT). Carbon may always be carbon to an organic chemist, but not to an investor.

So during periods of low volatility I found myself addicted to the returns, but disappointed in the new realities offered by Dow Chemical and its credible cousins.

Flashback about 30 years, just before the Hunt brothers went bust in their attempt to corner the silver market, I actually bought a silver bar. I think it was 25 ounces, but I don't recall. What I do recall is that with a chance to run up the price over the last 30 years it still hasn't reached its one time glorious peak. Talk about a non-performing asset.

Forget about compounding the issue by getting inflation calculated into the equation. Trust me, it's still not worth what it once was.

Long ago lost, I just found the bar in a box buried in the deep corner of a basement storage area. It was tarnished in more than one way.

As much as we all stand in awe of technology, how awesome is it that you can now own gold and silver in the form of a piece of paper and not worry that some con artist is funding his retirement with your money? The great thing is that ETFs don't tarnish, although I suppose that the certificates can fade and yellow, but this is not your grandfather's stock market. No one holds certificates.

Somehow, and I don't recall the circumstances, I got interested in the ProShares UltraShort Silver ETF (NYSEARCA:ZSL). Its value changes inversely with the direction of silver prices. You may have noticed that silver prices move inversely with logic. So if you're looking for a volatile product within the precious metals sector, you've got volatility compounded, especially when the product is a leveraged ETF.

My first venture into the anti-silver waters was in April 2011 and only in a small way, as caution always prevails.

Any good student of investing knows that most all "experts" talk about the role that precious metals should have in a portfolio. Unless you're a Ron Paul groupie, that proportion of the portfolio that's composed of precious metals should be small, maybe 5% and not in the 140-150% range that Congressman Paul would advocate if that were possible.

My intentions were to stay in that more traditional range. Of course, my intentions were also to be a Rock God at one time and that didn't really work out.


But somehow, as time trickled on, purchases of the ETF ended up accumulating shares in my account, as I was easily enticed by the predictable up and down movements in share price and option premiums that ensued from that kind of price volatility.

As if owning an inverse product wasn't confusing enough, add to the mix selling covered calls. On any given day you can find yourself baffled as to whether you want the price of silver to move up or down.

Normally, when I discuss stocks, I never talk about how many shares I hold. Other than the IRS, it is no one's business. The exception was the recent homily about Green Mountain Coffee Roasters (NASDAQ:GMCR), as sometimes that level of detail is necessary to demonstrate a point.

In this case, I'm going to break the rule again and give a trade by trade account of my personal odyssey with silver and how I was able to create an almost 32% annual rate of return, despite the fact that the price of the underlying ETF has been virtually unchanged during the beginning and ending periods of the observation. And when I say "unchanged"," I mean down.

But when I say the end of the observation, that's all that I mean. I'm not talking about an end to the practice that I'm going to describe. It's just that at some point the formal observation has to stop so that you can relay the experience.

First, let me give you the summary statistics:

As of May 4, the value of my shares of the ProShares Ultra ETF, including the amount that I'd be on the line for if puts were assigned was approximately $199,200. At its peak, I either owned or was on the hook to own 18,600 shares if puts were assigned.

The cumulative cost of those shares was $212,398. At the beginning of the one year observation period ZSL shares opened at $13.24 and at 11 AM Thursday morning (May 4, 2012), shares were at $12. That represents a loss of 9.5% on the shares and a 6.2% decrease in the value of my ZSL holdings.

Pretty lousy investment, right?

During the same time period April 29, 2011 - May 4, 2012, the S&P 500 has gone up 0.7%

I guess that if I factored in the nearly $67,330 in option premiums the return may be a bit better. (Note: If you are poring over the Table in the link below, May 2012 option contracts are still open, therefore they show as a debit. Upon expiration, that debit is removed and an equally sized gain is realized. The $67,330 figure represents the realization of the May 2102 option premiums.)

How does 31.7% on an annual basis sound? Want to see the trading details?

As I looked at the linked above table for the first time, what struck me was how infrequently my shares had been assigned. I'm actually in jeopardy of venturing into long term territory, which if you follow my Transaction History is not very common, as I usually anticipate a 20% weekly turnover of other holdings due to assignment.

What struck me was that as good as the return has been, it could have been much better. That's because there were protracted periods when the price of the ETF was depressed, as silver prices were high for relatively prolonged periods of time. During those periods not all of my shares were hedged, thereby representing lost income opportunities.

As of Wednesday, all of my long ZSL holdings were hedged for the first time in about 4 months. In the meantime, it became clear that I had to look for ways to create even more reliable income streams while continuing to limit risk. That called for an expansion of my thinking, which itself can lead to discomfort.

Even when I began to fret that the ProShares UltraShort Silver ETF had quietly grown into too large of a position for comfort, I realized that there were other opportunities, such as selling puts during times that the ETF share price was depressed, despite the fact that option exercise would result in even more shares, adding to the discomfort.

Those put premiums were great, just as the call side premiums were during the ascendent portion of the ETF's price.

Then came another realization. Why play only the short side of silver? Uh duh.

Even though the beginning and end points of the price over the course of the year may have been essentially the same, the intermediate prices have been anything but, as the trading range was large.

In comes the ProShares Ultra Silver ETF (NYSEARCA:AGQ). It is everything that the UltraShort product is, just the anti-anti silver, meaning that it moves with silver prices, and leveraged, to boot. I guess it would be more efficient to refer to it as "Turbo Silver." Not surprisingly, it had great premiums as well on both the call and put sides.

And so the very simple, non-arithmetic algorithm arises. When silver was moving up you could sell calls on AGQ, sell puts on ZSL or buy ZSL shares.

When silver is moving down, you could do any combination of the opposite. You could sell ZSL calls, sell AGQ puts or buy AGQ shares.

The only wrinkle is that while AGQ shares have weekly options available, the ZSL has only the monthly variety. I'm OK with that hardship.

My only regret is that I didn't put that extra leg of the theory into practice sooner, but being the conservative sort, I had to go through the lengthy process of validating the hypothesis for myself before I would risk money that could be put to work in more familiar territory.

In the case of AGQ, just as in the case of ZSL, if you are assigned your puts, you just take that opportunity to write call options as you flip flop between wanting silver prices to move up or down. For each of the previous 3 weeks I have sold weekly $48 AGQ puts, finally being assigned shares on the May 04, '12 contracts. As the French elections shift sentiment across the European continent, I expect precious metals to open higher on Monday. In turn, I expect to sell in the money $48 calls on my new AGQ shares. In fact, I often like to sell the in the money calls after a sharp run-up in price, as my expectation is that there will be price retracement, yet by doing so, you maximize the option premium received.

The nice part is that it doesn't really matter if you play both ends. Even if it seems nonsensical to do so, the premiums are very real and they add up very quickly.

But if anyone asks you how you did so well, just skip the part about all of the hedges. It's just not as exciting to tell that part of the story, but for all of the extra cash in your pockets, you may as well hire someone to listen to your unabridged stories and suffer along as you revel in the sheer joy of low risk living.

Disclosure: I am long ZSL, AGQ.

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