Silver Strangle Play Both Sides Of The Market

10/06/09 09:41:14 AM

by Donald W. Pendergast, Jr.

Not sure which way silver will move in the next few months? Not to worry, there's a way to play such indecision by selling options.

Security: SI, SLV
Position: Sell

Silver has had a pretty good run over the past 11 months, rising by more the 90% from the sub-$9 crater that it crashed into after 2008's commodity landslide finally played out. It's actually been stronger than gold (in percentage gain terms) over the same time period, but unlike gold, silver has failed to reach the highs seen during March 2008. The weekly chart of silver also seems to imply that this commodity may be due for more pullbacks in price; fortunately for us, there is a way to play silver's short-term weakness and its longer-term bullish outlook.

FIGURE 1: SILVER, WEEKLY. While the future is unknown, we can still rely on probabilities, support/resistance levels, seasonal tendencies, and supply/demand fundamentals to create logical option spread strategies.

Graphic provided by: MetaStock.

Graphic provided by: WB Various indicators from ProfitTrader.

Figure 1 is silver's weekly chart; while the metal has traced out a nice upward trending price channel, a glance at the detrend oscillator (top panel of chart) reveals that silver is progressively losing momentum even as a very reliable cycle indicator, the WB B-Line, is also suggesting that a medium-term top is likely to print soon, if it hasn't already. Going further, note the significant overhead resistance that spans the price range between $18.15 and $20.70 and then the significant support area near $8.81. This $10+ price range between major support & resistance barriers is likely to contain silver for the foreseeable future, and this leads me to suggest the sale of a far out-of-the-money (OTM) short option strangle. With silver usually being weak to flat during October/November (based on a reliable 40-year seasonal pattern) every year, selling a short strangle becomes even more appealing, especially for those who appreciate the value of time decay on a short option position.

Silver does have a rising weekly monthly price cycle (not shown here), however, so we're going to bias the trade to be a bit more OTM on the upside than on the downside. This shouldn't be an issue for long-term silver bulls (myself included), and will also help secure extra premiums on the put side of the strangle. Follow for all the key details.

Based on recent option prices, selling a COMEX March 2010 silver $30.00/$10.50 strangle should net nearly $600–650 cash for your futures margin account. As long as silver remains between $30 and $10.50 by March 2010 options expiration (February 23, 2010), the entire spread will expire worthless, allowing you to keep all of the premiums collected up front. Along the way, the value of both short options will slowly erode, due to the effect of time decay (positive theta). The biggest danger to this option spread is if silver mounts either an unusually strong rally or selloff shortly after the position is opened. In such a case, either the put or the call can rapidly increase in value.

Of course, the option on the other side of the spread will also have lost a large part of its value at the same time, thus neutralizing at least part of the sudden spike in the price of the underlying commodity. Should such a spike occur, the best strategy is to determine how likely it is for either side of the strangle to go in-the-money and to make the necessary adjustments.

For example, let's say silver breaks hard to the downside a week after you sell this spread, all the way down to $12. The short put would gain a great deal of value, while the short $30 call would lose a part of its value. In such a case, you could always buy back the short $10.50 put and roll out to a March 2010 $8.50 put, especially if you were confident that silver's strong support at $8.81 would stop any further declines between then and option expiration. You could even buy back the $30 call and sell a $25 call in its place, locking in some extra profit at the same time. The possibilities are numerous, and experienced option traders should have little problem with such a short strangle, no matter what the future may bring for silver.

If I were to enumerate the key skills needed for futures option sellers, here would be the basic list, in no particular order of importance:

1) Understanding of key S/R levels on multiple time frames.
2) Knowledge of option implied volatility.
3) A firm grasp of statistics and probabilities.
4) Familiarity with seasonal commodity price charts.
5) The ability to work a decent option fill price.
6) Knowledge of basic supply/demand for any given commodity.
7) The wisdom to know when to wait and when to act.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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Silver Strangle Play Both Sides Of The Market

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