All that glitters……

Posted on 07/28/2011


… not Gold, so why not trade Silver?

I mentioned in the first SI recommendation (selling the 43.50 calls) my preference for Silver options (SI) as opposed to Gold (GC) because it’s inherently a more volatile product.

Volatility is NOT a four letter word in my experience, nor is it something that ought to be avoided. Volatility equates to opportunity. A volatile product presents greater/more frequent relative “mispricings”.

Generally, Silver options trade at a slight premium to historical (10/20/30 day) volatility. For example, if 20 day historical vol is 39 1/2 (which is about right now), options may trade around a 41 or 42 implied vol (premium to historical). Once in a while SI options will trade at a discount to historical, in which case premium is probably a buy (or at least not something you should be short).

Right now the spread between historical (realized) vol and implieds is wide. September options expire in 28 days (August 25th) and 30 day historical (realized) vol is 37%.  However, September implieds are selling around a 43 vol, so the spread is +6. Make sense? In my opinion, a +3 is “fair value”.

This may present an opportunity. I think the relatively rich spread can be understood in geopolitical terms (domestic debt ceiling talks continue to falter, Greece, Italy, Spain, Portugal, Ireland – pick a periphery country in Europe –  have sovereign debt issues, and there is pervasive talk that China’s growth is slowing….and when in doubt, you can just blame the Japanese earthquake for uncertainty) and so in “context” perhaps the elevated implieds make sense.

Let’s look at this another way. If you own (buy) 43 vol in Silver with the underlying around $40, you need $1.05 moves every trading day to cover your decay (theta). Could that happen? Absolutely, but I doubt it will continue to happen. (I can explain the formula for daily vol moves to cover decay, but for the time being it’s not pertinent).

That said, I want to be SHORT some SI vol and DELTA neutral. I don’t care if Silver moves up or down on any given day…..just that it stays within a defined range over a finite time frame. Statistically speaking, I prefer this approach – more passive, but with considerable risk.

TRADE RECO: Sell to open the Sept Silver (SI) 45 calls AND 35 puts @ .65 or better. If you collect .65 in SI that equates to $3,250.00 in dollar terms. DO NOT OVERLEVERAGE yourself. I would only sell ONE strangle for $10/$15k in account value/margin (3X1 or 5X1). Your EXPIRATION break evens excluding frictional costs will be $45.65 and $35.35 – which I think is a realistic range EVEN given political overhang. That band is about 14% around the current Silver price (which is vacillating either side of $40).

I expect implieds to contract if/when we get some more clarity on the debt ceiling negotiations (vote in the House around 6 pm tonight). If vols come in, that strangle should lose value.

I would COVER the strangle @ .20 (pay $1,000) if given the opportunity in before August 9th (the next FOMC meeting). I would also BUY BACK either side of the short for .05 if possible. For example, if Silver rallied up toward $43 and you could buy the 35 puts for .05….do it! Then leave a .15 bid to cover the calls GTC.

Good trading! I tried to include a graph with historicals v. implieds, but for some reason I’m having difficulty.

P.S. To be clear – I am NOT making light of the Japanese earthquake. It was a tragedy on so many different levels. I just think it’s a stretch for a company that’s totally unconnected to the electronics supply chain to use it as “cover” for underperforming expectations. Worth noting.

Also, with Silver above $45.65 or below $34.35 losses on this position are unlimited. For example, if Silver expired at $47, you would LOSE $1.35(5,000)=$6,750 per contract (assuming you trade the big and not the mini or an ETF).

Posted in: Silver, Trade Ideas