A Simple, Low-Maintenance Strategy for Metals Exposure

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A Simple, Low-Maintenance Strategy for Metals Exposure

By Brian Benson, On Course with Options

 

Why Invest in Metals?

Gold and silver have historically been valued as a physical store of wealth and a hedge against economic risks such as inflation. Moreover, for diversification purposes gold and silver often have poor correlation to stocks.

Factors driving the price of gold and silver include industrial consumption, the jewelry industry, interest rates, relative US dollar strength and inflation fears.  Ultimately all of those factors boil down to supply and demand.

 

Cost of Carry

There is however a traditional drawback to being long gold or silver, whether it be with physical metal, futures or an Exchange Traded Fund (ETF) like GLD or SLV.  There is no dividend or yield available.  Additionally, the costs of ownership such as transportation, storage and insurance are allocated out over time or otherwise built into the market price.

One way to compensate for the lack of yield on gold and silver is to purchase shares of an ETF such as GLD or SLV and write call options against those shares.  This is a relatively straightforward strategy of writing “covered calls.”

 

SLV vs. GLD

Covered calls tend to have greater profit potential on lower-priced underlying assets.  The amount of call premium available as a percentage of the underlying price is generally higher for relatively lower-priced shares.  For example, at this writing with SLV trading at $16.68, the 1-strike out-of-the-money (OTM) 17 call option that is 53 days-to-expiration (DTE) is trading at about $0.46.  That option premium is about 2.75 percent ($0.46 / $16.68 * 100) of the current market price.

With GLD trading at $140.64, the 1-strike (OTM) 141 call option that is 53 (DTE) is trading at about $2.68.  That option premium is about 1.9 percent ($2.68 / $140.64 * 100) of the current market price.

By that comparison, option premium on SLV is a little richer than option premium on GLD.

There’s another reason to do this strategy with SLV rather than GLD.  At this writing with SLV shares trading at $16.68 the capital outlay to purchase 100 shares would be $1,668.   Compare that to GLD trading at $140.64 where the capital outlay would be $14,064.   You can do the SLV covered call trade and tie up a lot less capital.

For these reasons, I tend to favor this strategy for SLV versus GLD.  This strategy can certainly be used with GLD if that’s your preference, but you’ll tie up more capital and generally have a slightly lower maximum profit potential as a percentage of that capital.

 

Entering the Trade

To write a covered call you have to own 100 shares of the underlying for every call sold.  You will need to purchase the underlying shares in round lots of 100.

You can try to purchase shares on weakness and sell calls on strength.  Getting the timing right can be a challenge.

You could initiate both components of the trade at the same time.  Most trading platforms have an order type called “buy/write” or buy “covered stock” where the shares are purchased and the call is sold in a single transaction. This is my usual preference and I only enter with a limit order so I know exactly what my debit will be for entering the trade.

I generally sell calls at least one strike OTM.  That gives a potential for at least some capital gain on the shares in addition to the option premium collected.   If your outlook is very bullish, you may want to sell calls at a strike price that is further OTM.

 

Selling Puts

As an alternative way to collect option premium and ultimately purchase shares, you could instead sell cash-secured puts.  The profit and loss graph of selling a put is the same as for selling a covered call.  Both are neutral to bullish strategies with downside risk (in theory) to $0 and a capped upside gain.

If you sell puts, you’ll likely have shares “put” to you at some point, and then you will own the shares at the strike price you sold.  Having shares “put” to you is not necessarily a bad thing.   With this strategy having shares put to you at a reduced cost basis is part of the plan.  When that happens, you then sell calls against the shares you now own.  The cost (or basis) of the shares you purchased will have been reduced by the cumulative option premium you’ve collected by selling puts.

A key thing to keep in mind when selling puts is you must like the underlying at the strike price you sold.  More importantly, don’t sell puts for more shares than you’re willing to own.   This is particularly important in margin accounts where more puts can be sold due to increased leverage.  Just don’t sell puts for more shares than you’re willing and able to purchase.    You really don’t want to commit to buying more shares than you planned on and end up with a position much too large based on your own account management and position sizing rules.

 

To leverage or not to leverage?

You can increase leverage and potential return by purchasing shares (or selling puts) on margin.   My preference is not to do that.  I take comfort in knowing I have fully paid for the shares I’ve sold calls against or, in the case of puts, I have 100 percent of the cash on hand to purchase the shares that I committed to (possibly) buy when I sold the puts.

Another thing I like about implementing this strategy without leverage is you can do it in non-margin accounts (i.e. IRAs and Roth IRAs) at many brokerages.

 

Theoretical Returns

Using the above example data on SLV, if you sold premium that was worth about 2.75 percent of the current underlying market price, and you did that about six times per calendar year, then you could in theory make about 16.5 percent (2.75 percent *6) return for the year.  That is without having shares called away from you.

If your shares were called away each expiration cycle, then you’d also have a gain of the difference in purchase price versus the OTM strike price sold in addition to the option premium collected.

Again, using the sample data above you could have a capital gain of $0.32 in addition to the $0.46 in premium collected.  In that scenario, the theoretical annual return could be in the vicinity of 27 percent ((($0.46 + $0.32) / $16.88 *100)) at 6 expiration cycles per year).

Keep the variables in mind. Actual results over time could vary substantially.   Implied volatility can greatly affect the amount of premium collected and can vary substantially.  You may not have a great opportunity to sell premium in every possible option cycle you’d like to participate in for the given year.  There will likely be times where the underlying may be down and you may want to wait for price to recover before selling calls.   And of course, actual expiration cycle outcomes are likely to be a mix of having calls expire worthless in some cycles and having shares called away in other cycles.

 

Trade Management

Writing covered calls is a relatively low-maintenance strategy that doesn’t have to be monitored continuously.  Once you write calls, the shares will either be called away or not.  Either outcome should be okay most of the time.

If the calls you sold expire worthless, you still own the shares.  In this case, sell calls again for some future expiration cycle and collect more option premium.

If your calls expire in-the-money, your calls will be exercised, and the shares will be called away.   The shares are purchased by the counterparty at the strike price, and you no longer own the shares.  As the call seller, you keep the premium and any gain on the shares.   In this case, you may want to start the process over again by buying shares or selling puts.  Once you own shares again you can write calls.

 

Downside Risks

As with any strategy, it’s important to ask and understand “what could possibly go wrong?” before deciding to get involved.   We have to keep in mind writing covered calls (and selling puts) is a neutral to mildly-bullish strategy.   There is always the risk of a sustained down-trend in gold or silver that could hurt strategy performance.   Just because these are commodities that (in theory) won’t go to $0, it’s important to keep in mind there can certainly be sustained down trends, price shocks and changes in volatility that will affect strategy performance.

 

Upside Risk

There is always a tradeoff when selling covered calls.  In exchange for collecting option premium, profit is limited to the amount of premium collected plus any appreciation in shares up to the strike price.

If your outlook is strongly bullish and you’d rather position yourself in a directional trade with unlimited profit potential, then don’t sell the call.  If the bullish case plays out, your profit could potentially be greater by simply owning the asset or a proxy for the asset.

Probability and repeatability are benefits of selling the covered call (or put). With the covered call strategy, you don’t need large up moves to make a profit. The underlying share price can go up, sideways or even down a bit and you can still profit.

Additional Information

More details about the basics of selling covered calls are available from many sources, including here:
https://www.cmegroup.com/education/courses/option-strategies/covered-calls.html

And, similarly for selling puts:
https://www.cmegroup.com/education/courses/introduction-to-options/explaining-put-options-short-and-long.html

 

Disclaimer:  The author is not a financial advisor and the following should not be taken as financial advice.  This is by no means a complete discussion of the pros and cons of trading and/or investing. Please consult your own qualified advisors to determine what is appropriate and best suited to your specific investment objectives and risk tolerance.

2019-11-14T10:21:30-05:00
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