A Tale of 3 Sisters: Why Silver Could be the Next Hot Market for Option Writers
The 3 SistersYou may think of Gold and Silver as the same market. But the metals have distinct properties and do not always move in lock step with each other. In fact, you might think of Gold, Silver and Copper as 3 sisters, all from the same family, but each with her own personality. Gold is the glamour queen. Everyone’s favorite. Flashy. And temperamental. In the modern age, gold almost totally disregards core supply demand fundamentals and behaves like a currency market. This, interest rates, stocks, economic factors can all impact her price (although not really correlate it to anything). Copper is the Worker bee. Copper is the poster child for industrial commodities and its price is even used as a thumbnail gauge for overall economic health. Copper is all about supply demand fundamentals and tends to do well in times of economic growth and less so in times of economic slowing. Silver is the middle sister. It shares properties of both its glamorous golden sibling and it’s 9 to 5 lunchbox industrial one. A big move in gold can pull silver with it. But Copper can pull back, saying “no you don’t, she’s staying with me!” Thus, a factor that can fuel an outsized move in gold or copper will often get a more temperate response in the Silver market. At the same time, Silver can also choose to break from either copper or gold and follow the dominant sister wholeheartedly. For instance, in the most recent surge of investor related buying, silver broke entirely from copper and traded a very similar pattern to gold. This despite the fact that silver and copper demand are affected by many of the same factors at the industrial level. She can dress up and go to the red carpet event, or she can put on her overalls and go to work – it all depends on the occasion with silver.
The Fundamentals of SilverSilver has traded in lock step with gold for much of the past two months. But copper prices have remained weak, for a variety of factors. Not the least of these is the slowing of demand from China. Chinese copper imports are expected shrink by as much as 10% in 2016 as the Chinese economy faces the slowest annual expansion in a quarter century. Meanwhile, there are canaries dying in the coalmines here in the US economy. The US Monthly ISM Manufacturing Index (often referred to as an early indicator of US economic direction hit its lowest level since 2009 last month. While only one indicator, an argument can be made for slowing US growth from the chart below:
US Manufacturing index has fallen to its lowest levels since the recession in 2009.
The biggest headwinds for industrial and perhaps even precious metals moving forward is inflation – or more specifically, the lack of it.
The price index for personal consumption expenditures, the Fed’s preferred inflation gauge, was up only 0.6% in December from a year earlier. It has been below the central bank’s 2% target for more than three years.
The price index for personal consumption remains below the Fed’s target.
If inflation does not show signs of picking up soon, the Fed may be reluctant to raise interest rates further in 2016. Yet the January core inflation index (which excludes food and energy), increased by 0.3%, its largest monthly gain in 4 ½ years. What does all of this mean for Silver? Conflicting fundamentals for one. Volatility for another. That is the textbook recipe for a strangle.
Price Outlook and StrategySilver will remain vulnerable to following gold in another flight to quality should we see another sell off in equities. It could also push higher if the Fed takes a more dovish stance on rates, as the dollar will likely suffer as a result. But we think that would be a short term “knee jerk” type reaction. Longer term, the dollar should still remain top dog over other currencies. However, if the Fed does hold off, it would be a sign that the economy was weaker than first thought – likely a punch to copper prices and a drag on silver. On the other hand, should the Fed raise rates later this Spring, it would more or less be signaling a green light for the economy. This would be bullish dollar, bearish gold. But it should help copper. In short, for Q2-Q3 2016, silver could be caught between the opposite moods of it’s two opposite sisters. Last month we projected a rally in gold and suggested gold strangles. We were admittedly a bit early on the call side (although our suggested call strikes were never close to being reached.) But the volatility has pushed up the option premiums now, spreads are wider, strikes are deeper, and in our opinion, risk is now lower. By selling premium in Silver, you get the flight to quality buying shared with gold, along with the tempering effect of industrial demand from copper. We suggests selling the July Silver 12.00 put/21.00 call strangle for total premium of $900 -$1,000.
JULY 2016 SILVER
A strangle this wide should show good time decay and be able to remain profitable in a variety of situations. But it also provides a considerably large profit zone. Silver prices have not hit the call strike for over a year and a half and have not breached the put strike since 2009. We anticipate it staying that way for the next 120 days. That’s one sister you can take to the prom.