In case you haven’t been paying attention, gold has finally and enthusiastically jumped out of its 5-year rut. For more than half a decade, the precious metal has been stuck trading below $1,300 per ounce as the later stages of the global economic recovery continued to churn on.
As the economic picture began turning from optimism to caution over the last few months, however, investors have finally started flooding gold, sending its price from that sub $1,300 basement up past $1,500. Over the last nearly two months, it’s been able to sustain that new floor.
But gold is only one part – albeit the largest – of the precious metals picture. Silver, its flakier little sister metal, has followed along… until last week.
In a typical commodity cycle, gold leads, and silver follows. That seems to be the case this time around. The concern is that silver is more of an industrial metal. Meaning, if the economy is slumping, gold offers more of a safe haven than its little sister. However, when the gold trade becomes overcrowded, investors will turn to silver – and others like platinum – that offer similar protections.
Now, I’m not saying we’re already entering into a later-stage precious metals cycle, where silver vastly outperforms gold. But, for now in the short term, it appears gold’s large move out of its $1,300 rut has sent far too many people into the premier metal. Now, silver is getting attention.
Last week, after a two-week cool down for all precious metals, they caught another bounce. As the trade talks between the U.S. and China ended abruptly and European production hit 2008 levels, investors are again looking to shore up their risk protection with precious metals. However, with gold’s overcrowded position, silver was able to shoot up higher.
Friday was a great day for both metals. Yesterday continued that trend. Overnight, it appeared that rally had cooled. But that now seems to be a blip.
Now, if we zoom in on more recent price action for silver, we find a real opportunity… even if its just a short-term one.
As you can see, the metal did test new highs earlier in the month above $19.50. Right now, it’s going for about $18.60. The recent move higher on Friday – even higher than gold’s one-day move – points to a second attempt at that all-important psychological ceiling… $20.
If silver does continue to outperform the overcrowded gold market, we can play that second bounce towards $20. Fortunately, with a merger that just completed earlier this year, we have the perfect instrument for our trade.
Pan American Silver Corp. (PAAS) became the world’s largest silver company by in-ground reserves with its massive $1.1 billion takeover of Tahoe Resources in February of this year. As you can see, the company moves in near perfect harmony with the price of silver:
Today, with everything in alignment for silver to retest that $20 price point, we can use PAAS to take advantage.
Of course, we could just buy shares and wait. But a move from $17.82 to $19.50 or $20 would only produce a small return.
Likewise, we could simply buy calls on the stock, leveraging this small-sized movement. But that would still not produce the greatest returns unless silver did break above the $20 threshold… something we haven’t seen in more than three years. Even then, it didn’t last long.
No, instead of those ordinary trades on this price movement, we have a strategy that should maximize our profits. Let’s get right into it…
A Strategy For Short Term Bulls
A bull call spread is a type of options trade that uses one long call option with a strike price near the current trading price of a stock you believe will go up in value and a second short call with a higher strike.
What this spread does is offer income from the sold put to help offset the cost of the long one. This reduces the total cost, and therefore the amount at risk, for the overall trade.
In exchange for the cost reduction, it does come with a ceiling on the maximum potential profits one can receive. However, more often than not, that’s a tradeoff worth taking. For silver and PAAS, that’s definitely the case.
You can see how this trade works here:
Source: The Options Industry Council
Since silver needs to break above the $20 price point before we can call it a real breakout, buying a call option outright would be more like a gamble that it will shoot past that threshold than a smart trade. Instead, we can profit from the runup to $20, while reducing our risk.
The way this kind of trade works is that the closer the underlying stock trades to the higher strike (of the short call), the greater the profit. So, if we use a upper bound of $20 – which correlates to both PAAS and silver itself – we can profit from the run up to $20 without gambling on either breaking above it.
Let’s look at a specific example to see just what that looks like…
A Specific Trade For PAAS
Right now, a trader can buy an October 18 $18 call on PAAS for just $0.75 per share and sell an October 18 $20 call for $0.20 per share for a total cost of $0.55 per share. Since each call is worth 100 shares of PAAS, that’s a total net debit of $55 to open this trade.
Now, that $55 is the only amount at risk for the duration of this trade. The trader couldn’t lose a dime more than that if silver sits still. But if silver rallies, he stands to make even better money.
Like we noted, this trade profits the closer the underlying shares of PAAS get to that upper $20 strike price. So, to find the maximum profit potential here, take the difference in strikes ($20 – $18 = $2), and subtract the cost ($2 – $0.55 = $1.45). Again, on 100 shares of PAAS, that’s a potential return of $145.
In other words, this trader would be looking at a total maximum return here of $145 on the $55 he spent to get in on this trade, or a 264% return on his risk.
Shares would have to test that upper bound of $20 to see that full return. But even if it approaches $20, the profits will still be large.
To find the profit point – the price where this trade returns more than it cost to get in – simply add the cost to the bottom strike price ($18 + $0.55 = $18.55). Anything above that point is pure profit. Meaning, anything between $18.55 and a test of the $20 price point is money in the trader’s pocket.
Not often do we see such an opportunity – and a straightforward one – in the short-term movement of silver. But as investors continue to play gold’s little sister, smart traders can profit.