This Could Be the Best Way to Trade Silver
Silver is an inflation hedge, at least in some ways. It is a precious metal, like gold, but it trades at a significant discount to the price of gold. In fact, throughout history, one ounce of silver has often traded at less than 7% the price of gold.
That means silver is more accessible for individual investors with limited capital than gold is. Yet, the two metals often move in the same direction so silver, at times, is an inflation hedge equivalent to gold. And, like gold, investors can access silver in a number of ways.
Miners are a strategy to benefit from moves in precious metals that offer the benefit of leverage. An example might be the best way to explain the leverage miners offer.
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Let’s assume it costs a miner about $12 an ounce to produce silver and they mine 1 million ounces a year. If silver is at $15 an ounce, the company should generate a profit of about $3 an ounce or $3 million
This is a simplified example, so we will assume the company has no other costs and no additional revenue.
If the price of silver increase by 30%, to $19.50 an ounce, assuming the costs of production stayed the same, the miner’s profits would increase to $7.50 an ounce or $7.5 million for the company, an increase of 150%.
The miner is leveraged, in this example, 5 to 1, and benefits immensely from higher silver prices. Even smaller gains in the price of silver have a large impact on earnings. A 1% increase in silver prices (to $15.15 an ounce) results in a 5% jump in the earnings of this hypothetical mining company.
Remember, there is no free lunch in the stock market. Leverage can help increase investment returns on the upside but can cause significant losses on the downside.
A 1% decline in the price of silver could result in a 5% drop in earnings for this silver miner and we would expect the stock price to reflect the diminished earnings potential of the company. A 35% decline in silver could push the miner from a profit to a loss.
This leverage makes silver miners an excellent way to invest in silver. Buying miners when silver prices are low, as they are now, could result in relatively large gains if the price of the metal recovers.
A Miner Bounces on Earnings
Pan American Silver Corp. (Nasdaq: PAAS) recently reported “second-quarter net income of $36.7 million.
The Vancouver, British Columbia-based company said it had profit of 24 cents per share. Earnings, adjusted for non-recurring gains, were 23 cents per share.
The results exceeded Wall Street expectations. The average estimate of four analysts surveyed by Zacks Investment Research was for earnings of 16 cents per share.
The silver mining company posted revenue of $216.5 million in the period, also topping Street forecasts. Three analysts surveyed by Zacks expected $213.6 million.”
The stock price has been in an extended trading range and this news could provide a catalyst to push the stock out of that range.
A Trade for Short Term Bulls
As with the ownership of any stock, buying PAAS could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for PAAS
For PAAS, the September 21 options allow a trader to gain exposure to the stock.
A September 21 $17 call option can be bought for about $0.75 and the September 21 $18 call could be sold for about $0.35. This trade would cost $0.40 to open, or $40 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $40.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in PAAS the maximum gain is $0.60 ($18 – $17 = $1.00; $1.00 – $0.40 = $0.60). This represents $60 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $40 to open this trade.
That is a potential gain of about 150% in PAAS based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.