The appeal of precious metals as alternative investments is gaining ground as the euro continues to climb against the U.S. dollar. Silver futures for July delivery rallied 67.2 cents, or 4.1 percent, to $17.232 an ounce on Monday, June 16. It was the biggest percentage gain in nearly three weeks and was driven mostly by weakness in the dollar.
The dollar has gained a lot of attention because of its known impact on various commodities. People are wondering whether it will continue to sell off or if it will continue its mild rally.
You can see by the chart below that the U.S. Dollar Index futures have been in a brief uptrend over the last couple weeks. The moderate gain is tied to Ireland’s rejection of a Euro-zone referendum that would broaden European Union power. The U.S. dollar was also affected by fairly tame inflation data and possible signs of a slower U.S. economy. These factors, in my opinion, reduce the odds of a Federal Reserve rate cut anytime soon.
The silver market has recently been trading steadily in a range. I don’t believe the bullish metals trends are over. We may go back and forth in the silver futures market, as we have over the last few months, but I think the market will eventually retest its highs.
Instead of buying the futures on silver outright, I recommend using an options strategy called a ratio spread. This type of position can you help gain exposure to the silver market without bearing the excessive risk that can come with an outright futures contract.
The ratio spread for silver involves buying one September $18 call, selling one September $20 call, and selling two September $21 calls.
When I execute a ratio spread like this for clients, I enter it all on one order so that the entire position gets filled or it doesn’t. I work these types of orders directly through my contacts on the floor at the New York Mercantile Exchange. The traders will make a market based on this type of order by giving me bid-ask prices. I can then advise a client on the optimal way to work the order.
In this specific trade, the idea is to get this executed at “even-money” or preferably to bring in a credit. Executing the order at “even-money” means that all you pay is your transaction costs. In other words, the purchase price of the $18 strike is being paid for by the sale of one $20 call and the sale of two $21 calls.
The $18 call, as of this writing, is going for about 72 cents, of which, each penny is equivalent to $50. To buy that option outright takes $3,600 (72 x 50 = 3,600). So buying the $18 call option outright could be a fairly expensive position. Instead, the ratio spread brings that premium right back in from the sale of the $20 call and the two $21 calls.
If the position is executed at “even-money” and silver prices are trading below $18 at expiration, all you would lose is transaction costs. Keep in mind, however, that there is still an upside element of risk to this position because of the two naked $21 call options that are being sold. If silver rallies above its previous highs near $21, the trade could lead to a loss.
There is a possibility that this trade can also be executed at a credit, which would be preferable. Let’s assume the position was entered at a four-cent credit. This would cover the cost of the option and most likely your transaction costs.
If the silver market trades above $18 and stays below $21 at expiration, this trade would be profitable, with a max profit potential of $10,000. The position makes $50 for every penny above $18 and below $21. If silver reaches $21, you don’t automatically lose money. Instead your profit decreases on the way up and could eventually turn into a loss if silver makes a larger than expected rally. Your breakeven is on this trade is at $22.
The ratio spread is a good strategy for getting exposure to the upside potential of a market without having to deal with the excessive risks of an outright futures position. There are still risks associated with this trade, but they are more calculated and allow you to make changes to your risk management strategy if need be.
Michael Sabo is a Senior Market Strategist with Lind Plus. He can be reached at 800-798-7671 or via email at msabo@lind-waldock.com.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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