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Wednesday, July 18th, 2018 - Buy Gold - Bringing you trusted gold news and gold investing information since 2006

Silver: When a Breakeven Isn’t

By aBrad Zigler

Real-Time Monetary Inflation (Last 12 months): 0.9%.

We get a lot of questions whenever we present option strategies in the Desktop. Options are arcane to many investors.

No doubt, options can be complicated. Options can even seem inexplicable at times. Particularly baffling is this business about breakeven points.

Case in point: our February 10 column (“Options For Silver Traders,”) in which a bull call spread in the iShares Silver Trust (SLV) was presented.

Back then, when spot silver and the SLV trust were dancing on either side of $30, the purchase of an April $32 call could be partially financed by the sale of a $34 call, leaving the spreader with a capital commitment of only 37 cents a share, or $37. On paper – meaning at the contracts’ expiration date – the spread breaks even when SLV is at $32.37.

In reality, though, the spread turned profitable well before SLV reached the $32 level. On February 18, SLV finished at $31.79 but the spread was worth 69 cents ($69), 86% more than its original cost.

“How did that happen?” was the query heard most often over the weekend. The answer’s found in a single word – volatility.

Option prices are determined by a number of factors. Some elements are plainly discernable – the contract’s exercise price vs. the underlying asset and the length of time before expiration, in particular. There’s one element, however, that’s ethereal – the volatility assumption. That is, the market maker’s or trader’s assumption of future variance in the asset’s price. When little volatility is expected to remain level or decline over the lifespan of the option, i.e. when implied volatility is low, options are “cheap.” When a lot of volatility is expected, though, option premia (premiums, if you like) get inflated. It’s all about covering the risk to the option writer or seller.

Here’s the deal with the SLV calls. The volatility built into the contracts back on the 10th was cheap. Recent events have forced volatility expectations – and consequently, premiums – upward. The market was more or less complacent about silver’s prospects a couple of weeks ago. Silver’s price trajectory steepened recently and option volatility assumptions were ratcheted upwards, inflating their prices.

So what does this mean for our SLV spreaders?

First, we should look at SLV’s near-term prospects. Technically, we’re now looking at a $36 target. Here’s the spreader’s dilemma: hold on or get “unspread.”

This morning, as silver reacted to the weekend swirlings in the Mideast, SLV jumped to the $32.50 level. The spread, at last look, was worth 87 cents. That’s a 135% profit. The question for our spreaders now reduces to this: “How confident am I of a move above $36 by mid April?”

At this point, spreaders could buy back the $34 calls sold to finance their long call positions. That means paying the current $1.28 ask ($128 per contract), leaving them with a naked long position in the $32 call (now worth $2.15 per share, or $215).

The purchase would set spreaders back 87 cents a share on the call sale, a price too steep to pay for going bare. At least for now. Better to stand pat and see what develops.

We’ll be watching the spread for future developments. So should you.

The original article is published at http://www.c2ads.net/full-text-rss/makefulltextfeed.php?url=http://seekingalpha.com/sector/gold-precious.xml&format=rss&submit=Create+Feed


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