One of the worst performing asset classes this month has been silver. The entire metals complex has been sold hard since the Fed's announcement last week, and the move has left many traders perplexed.
Typically silver, like gold, is seen as an inflation hedge, or even a fear trade, and would be expected to appreciate after the Fed announced that it would increase its asset purchasing program.
We trade gold and silver based on a macroeconomic model, and have found that part of the sell-off in metals has been due to a "risk on" trade. Funds are buying riskier high-yield debt and selling metals, thus dumping non-yielding assets while searching for yielding assets. We also suspect that there has been short-term pressure on the metals due to end-of-year profit taking and fund liquidation.
Thursday, one trader sold January 29 calls, and January 29 puts, in the iShares Silver Trust, which is the physical silver ETF. This was done for a net credit of $1.55, and it is a bet that silver will remain bound in a range between about $27.50 and $30.50 over the next 28 days.
Our models suggest gold and silver are near their fair value at current levels, and so I would expect only a small move to the upside over the next month.
The silver market is much smaller — and therefore more volatile — than the gold market so silver is used as a beta play on gold. This makes silver options relatively more expensive than gold options, so there is more premium to be collected by selling options. But of course, with more potential reward comes more risk, and there is a reason for these higher premiums — silver has been known to move over 3 percent on a daily basis. (Read More: Even With a Deal, This Big Name Could Still Fall Off a 'Cliff)
While I like the idea of betting that silver will be range-bound, I think this trade, with unlimited risk in both directions, is too risky. Further, I do prefer to trade gold, because it is less volatile. Because I am mildly bullish on metals here, I have initiated for myself and clients a covered call position in the SPDR Gold Trust. That means I am long the ETF, and short a slightly out-of-the-money call.
My position will profit if gold is flat to higher.
