Dollar Hits Record Low, Strategy for Silver

by Michael Sabo

The U.S. dollar fell to record lows on Thursday after the European Central Bank left its benchmark rate steady. The euro reached a record $1.5370 as crude oil futures followed, rising to a record $105.97 a barrel. Meanwhile, gold reached a reocrd high of $995 an ounce on March 5. Although gold has been the talk of the town, silver is an often overlooked metal that provides great trading opportunities.

Silver futures have been in a strong bull market since the end of last year. I’m going to discuss a silver trade that is ideal for the current market situation. In order to understand this approach to silver, we need to understand the overlying economic environment. In doing so, we’ll look at some important factors that play a part: the stock market, housing market, the Federal Reserve, and the U.S. dollar.

Let’s start by talking about the equities, or stock market. There is a lot of evidence out there confirming that we have been in an economic slowdown which has led to a stock market in decline. Many analysts, including famed investor Warren Buffet recently, believe the market is pricing in a recession. I’m a firm believer that we are currently in a recession. At this point it’s a matter of figuring out how long and how deep it will go and what the Federal Reserve will do to shorten it.

We have emerging troubles happening in the commercial real estate sector. This is coupled with the already familiar problems in the residential sector. Subprime still continues to have an effect on the market. There are still new developments happening with this problem and I think it will continue to weigh in on the market.

Some people believe we could see a recovery some time later this year, but my opinion is that I think it will still take quite some time to work itself out. The best way to approach this market now is with caution.

Here are some other fundamentals to keep in mind. Sharp increases have been seen in U.S. borrowings, offsetting the exploding U.S deficit. There was also weakness in construction spending and a weakness in the Institute of Supply Management’s (ISM) January manufacturing reading, the weakest in five years. We haven’t had the greatest of economic news entering this market.

I’m not trying to preach complete gloom and doom on the U.S. stock market. Instead, I believe we’ll see a bit of a sideways market. There are great ways to approach markets that move sideways. In this article, we’ll discuss one way in regard to the silver market. If you would like to learn about how sideways strategies can be applied in other markets, you are always more than welcome to call me at 800-798-7671 to discuss these strategies.

If you look at the U.S. dollar, it is clearly under pressure from a technical and fundamental perspective. I see continued weakness in the dollar. That will obviously have an impact on not only the silver market, but other commodities as well. We have evidence of more subprime problems, which will drive more weakness in the dollar. This Friday’s (March 7) February employment report, particularly, the non-farm payrolls number is the only near-term news that could help the dollar make some gains. And that would happen only if we saw a surprise reading from the non-farm payrolls number. If that number doesn’t come in better than expected, we should continue to see weakness in the dollar.

A lot of people are talking about a 75 point basis cut in the short-term interest rate at the March Federal Open Market Committee (FOMC) meeting. Although I think that’s a little excessive, there is some talk out there of it. I think it will be a quarter or, most likely, a half-point cut. However you look at it, it spells trouble for the U.S. dollar. If the FOMC does cut 75 basis points, it could even spell trouble for the equities as some will start thinking, how much trouble are we really in. How much farther can we go?

This is more of a bearish sign for the U.S. dollar/euro pair than the dollar/yen pair because the European Central Bank has held its rates steady to fight inflation. The weakness in the dollar presents us with an opportunity to place a strategic trade in the silver market.

Silver Strategy: One-by-Three Bull Ratio Spread

Who would’ve thought we would have $20 silver? If you look at the July silver futures chart below, at the end of October, we had silver prices sitting just below $15, and many viewed that as near a top.

My current recommendation is to execute a one-by-three bull ratio spread in the July silver futures market. This involves buying one $20 call option and selling three $25 call options against it. My clients and I started working these orders last week (February 25-29). At the time, the market on these call spreads was -10 / +10 cents and we entered the bulk of the orders at 3 cents.

When I execute option orders for my clients, I call directly down to the exchange trading floor. This currently is the best way to work option orders in my opinion. I know a lot of people do online trading, which of course, has it’s advantages, but for executing complex option strategies like this, it can be an advantage to have someone who can take your orders directly to the floor and knows how to work them.

I call a floor broker and mention that I want to do a one-by-three. He or she in turn gives me the current bid-ask price so I can enter into the trade as an all-or-nothing trade, rather than legging into it, which can be riskier. I think this is very important, especially in dealing with the silver market.

How this Strategy Works

This one-by-three call spread simply means that we are bullish on the July silver futures. However, you don’t want silver prices to go to the moon because you’re sitting on one long $20 call against three short $25 calls. Your one long $20 call will cover one short $25 call. Basically, that’s like a bull spread, but you have two extra shorts out there, the $25 calls. The reason I recommend this is because you receive a lot of premium for those $25 calls, and you bring that premium in right away.

In a sense, you’re short, or naked, two $25 calls. When you apply the premium on the three that you sold, to the one that you bought, it costs you approximately 3 cents, or $150, not including commission costs. This position anticipates that the bull market in silver will continue. Some skeptics will say silver is too high, but this was also heard when silver was $15.

The point I’m trying to make is that this is a bull market, and trying to pick tops in this kind of market can be a very dangerous and expensive thing to do. That doesn’t mean we go out there and just buy everything. We can’t do that because there will be market noise. Sometimes temporary moves to the downside can clearly bump you out of the market, even if the trend is still up.

Let’s look at the deltas of these options. In a nutshell, the delta is the rate of change the option is going to change relative to the underlying future contract. When this trade was originally put on, the delta on the $20 call was 0.46, commonly quoted as 46. The delta on the $25 calls was 0.19, but that’s 19 times 3, which brings us up to 0.57, or just 57. So if you look at this, we’re 46 at 57, which means that with silver going up a little right now, the increase in the option premium on the $25 calls is slightly greater than what we’re gaining on our $20 call.

In other words, we’re technically a tad bit, net short the silver market. You might be wondering, why we would want to be technically net short. Well, we don’t want to be, but because of the time value, delta and volatility in the market, we end up being at this current point net short. This means that you have to have some capital to weather through this trade. Initial margin on this trade, when originally entered, was $1,500, about 25 percent of the usual margin needed to trade silver futures. This is based on span-margin.

The key to understanding the delta is that we want the market to go up in a nice stair-step fashion as it has been doing. We’ve had nice up days along with some pull backs. If we see a break, let’s say $2 down, we can actually make some money because we’re a little net short. If the market breaks and you don’t think it’s going to turn around, then you can unwind the position and potentially make some money. The overall idea however, is to hold the position.

Downside Risk

In this one-by-three bull ratio spread, we have to be concerned about large spikes in the silver market, especially when we first put these trades on because it can affect your net liquidity. You have to be able to weather that both emotionally and financially. That would make our short $25 calls gain a little more value than the $20 call.

The big benefit of this trade is if we’re dead wrong, we limit our downside potential. Let’s say two months from now, silver is down at $15 and keeps on falling. With this trade, if you paid out 3 cents in premium plus your transaction costs, that is the most you can lose if silver falls, even if it falls to $10 an ounce. Losing 3 cents on the trade would be equivalent to losing $150 plus your commission costs. Thus, downside risk is very minimal.

So to reiterate, you are long a $20 call and short three $25 calls. You paid 3 cents, or $150, plus commission costs. From $20 to $25, that is a $5 per ounce move in silver. Each dollar move in silver is $5,000. So we have $5 times $5,000, which equals $25,000. This means that if June 25 comes and we’re correct, and July silver is trading at $25 an ounce, you can unwind this trade for $25,000 minus your commission costs. If silver falls sharply and we are wrong, the most you can lose is 3 cents, or $150, plus your transaction costs. Therefore, our downside risk is very minimal and upside risk is very large.

Managing the Trade

The way in which you manage this trade depends on how quickly it approaches $25. Typically, if it starts trading through $25, at some point you are going to want to cover it by going long futures. In this case, you would go long two futures contracts and the market could go to the moon. Then you look at option expiration to have everything exercised and offset.

If this move above $25 happens early, you may consider buying back those short calls and rolling those short calls out even higher. Or, add on futures or roll the calls out to a further month, giving you more time. So there are a lot of different risk-management techniques available if things don’t go your way in this trade. This is great because it allows you to look at multiple ways to adjust the position. This flexibility gives you more chances to try and make a profit. Obviously, there is no guarantee that the adjustments you make will create a profit, but it at least gives you a fighting chance.

This strategy is great for markets where we see strong fluctuations, within a bullish trend. If you just went long a futures contract, it’s very easy to get stopped out one day, while the market continues later that week and month to resume its way to the upside. In my opinion, utilizing a stop to cover an initial futures position is not the best way to approach this market for a long term trading strategy; maybe for the short-term. Recently we’ve seen fluctuations in the silver market of 50 cents to a dollar.

I think this silver strategy is going to be a phenomenal play. If you’re interested, there is a lot to understanding this and I used numbers that are already in the past. If you would like to discuss the current market prices and how this trade would apply, you are more than welcome to calling me at 800-798-7671 for an update on this strategy. This can also be applied to other markets as well, but I think you have to be selective with them. Right now, I think this works best with silver.

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.