How to Buy Silver At a Bargain Price Using Options

By: Money_Morning

Larry D. Spears writes: In last Wednesday's Money Morning special report on silver, several of our financial gurus projected higher prices ahead for "the other precious metal." Since then, silver has climbed about 5% -- hitting $43 an ounce yesterday (Monday). Silver is now nearing its record high of $50.35 set in January 1980.

For those with significant profits already in hand from silver's hot streak, Money Morning has offered some strategies for protecting those gains against a near-term pullback. But if you haven't yet jumped on the silver bandwagon, don't worry. You can still climb aboard without risking too much.

Exploring Your Options
The best way to implement this silver-buying strategy is to use silver options.

Buy an at-the-money July Comex silver call option, which gives you the right to buy one Comex silver futures contract at any time between now and the option's stated expiration date on Monday, June 27.

We've chosen the options on July futures because they carry beyond the June 22 meeting of the U.S. Federal Reserve's Open Market Committee. Many experts, including Money Morning's Martin Hutchinson, feel Federal Reserve Chairman Ben S. Bernanke could begin raising interest rates at that meeting, which could spell the end of silver's rally. If you disagree and want a longer time frame, you can opt to use the options on September or December futures, which don't expire until August 25 and November 22, respectively.

The at-the-money July calls, based on the closing July silver futures price of $41.825 on Thursday, April 14, would be those with a strike price of $41.50 an ounce or $42.00 an ounce. For this particular play, we feel the numbers work better with the July $41.50 calls. The price of those calls should track the July silver futures price very closely, so your profits would rise on an almost dollar-for-dollar basis with the futures contract - minus the initial cost of the call.

That, of course, is the major drawback of an outright call purchase - options on futures are expensive. At the close on April 14, the July $41.50 silver call option was quoted at $2.690 per ounce, or $13,450 for the full 5,000-ounce contract. That would mean the silver futures price would have to rise to $44.190 before you would merely break even - not impossible, but daunting nonetheless.

Thankfully, there's an alternative that makes this a much more attractive and affordable play. Because of silver's prolonged rally, the implied volatility of all silver options - the most important factor in setting their premiums - has risen to near-record highs.

That means prices for silver put options also are quite rich - which is why, in this strategy, you should combine the purchase of your at-the-money $41.50 call with the sale of an out-of-the-money put. In this case, that would be the July Comex silver put with a strike price of $40.00 per ounce. This particular put gives its buyer the right to sell to you one July Comex silver futures contract at a price of $40.00 per ounce up until the June 27 expiration.

The closing price for that put on April 14 was $1.825 per ounce, or $9,125 for the full 5,000-ounce contract. If you subtract its price from the price you paid to buy the July $41.50 call, the cost of your bullish option combination on silver would be just 86.5 cents an ounce, or $4,325. Not bad for a position that could give you a profit of nearly $40,000 if silver futures return to the record high of $50.35 an ounce!

The key features of this strategy are:

•Your break-even point if July silver keeps rising is $42.365 an ounce, and your profits are unlimited beyond that, rising dollar-for-dollar with the futures contract.
•Your risk is limited to the $4,325 net cost of the options until July silver falls below $40.00. That compares with a loss of $9,125 you would suffer if you bought the silver future itself and it pulled back to $40.00 an ounce.
•No matter how much further silver falls, your loss on the option combo will always be $4,800 less than it would be had you merely bought the future.
•If you choose to let the put be exercised (rather than buying it back), you will have to buy the July silver future at $40.00 per ounce - as promised, a bargain relative to its current (April 14) price of $41.825.
•You will have a margin requirement on the sale of the put - probably around $11,750, depending on your brokerage firm - but that's roughly the same minimum deposit you'd have to post if you simply bought the futures contract.

The accompanying table shows various possible outcomes for this trade at silver futures prices between $30.00 an ounce and $50.00 an ounce.

A Less Pricey Way to Play
If you don't have a futures account or dealing with contracts worth more than $200,000 each makes you nervous, you can use this strategy with equal ease on mining stocks - e.g., Silver Wheaton Corp. (NYSE: SLW) - or, for a more direct play, on one of the silver exchange-traded funds (ETFs) that have options.

For example, if you decided you wanted to make a play on silver, but wanted to limit your investment to $20,000 or less, you might make a similar play using the options on the iShares Silver Trust (NYSE: SLV). It's the most widely traded silver ETF, with a recent (April 14) price of $41.07.

Specifically, you could buy four SLV July 41 calls at $3.00 per ounce, or $1,200. The calls would give you the right to buy 400 shares of SLV - each roughly equivalent in price to one ounce of physical silver, meaning the total value of the 400-share position would be $16,428 (again, at April 14 prices) - up until the expiration date on Friday, July 15.

However, you would offset most of the cost by simultaneously selling four July SLV July 38 puts at a price of $1.70 each, or $680 for all four options. That means your net cost for the position would be $520, and you get an even more attractive scenario than with the futures because that would be your maximum loss until silver dropped below the $38.00-an-ounce strike price.

To clarify that, check out the accompanying table, which shows various possible outcomes for this trade at SLV share prices between $30.00 and $55.00 (equating closely to the same per-ounce silver prices). (Note: You would once again have a margin deposit on the sale of the puts, which would likely run about $520 each, depending on the margin formula used by your broker. You would also have to leave the money received for them in your account for the duration of the trade.)

There's no question silver has had an outstanding run-up over the past eight months, and if you haven't gotten on board yet, you may feel like you've missed the boat. However, this strategy proves that it's not too late to make a play on silver's bull run.

Source : http://moneymorning.com/2011/04/19/...

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