If you listened to Money Morning's recent special report from global resources expert Peter Krauth, you know the long-term outlook for silver is decidedly positive.
Soaring investment demand, continued industrial use, a growing supply shortage, and falling ore quality all signal a sharply bullish outlook for the "poor man's precious metal."
So, how can you position yourself to profit from silver's coming advance without exposing yourself to the excessive risk?
One way is to use options – either on silver futures contracts or shares of silver-related stocks and exchange-traded funds (ETFs) – in a strategy that strictly defines and limits your risk while still offering short-term returns of 100% or more.
Silver Options: How to Create a Bull Call Spread
Known as a "bull call spread," this technique involves simultaneously buying and selling two call options with the same underlying security and expiration date, but with differing strike prices.
Typically, a bull call spread involves buying an at- or slightly in-the-money call option – one with a strike price very near the current price of the underlying asset – and simultaneously selling an out-of-the-money call option with a strike price several increments above the current security price.
The difference between the two strike prices is referred to as the "spread."
To illustrate, let's look at an example using options on silver futures, which are traded in the CME Group's Comex division. In this case, one futures options contract represents 5,000 ounces of silver.
To create your bull call spread, you would purchase the slightly in-the-money July $33.00 call, quoted at $3.451 an ounce ($17,255), and simultaneously sell the out-of-the-money July $35.00 call at a price of $2.572 an ounce ($12,860).
The net cost of this spread is 87.9 cents an ounce ($3.451 - $2.572 = $0.879), or $4,395. That is also your maximum possible loss on the trade should the July silver future stand below $33.00 when the options expire on June 26, 2012.
What's more, the spread trade breaks even at a July silver futures price of just $33.879 as opposed to the break-even price of $36.451 had you merely purchased the $33.00 call alone.
So, what's the catch?
Simply this: While the spread trade has a maximum possible loss ($4,395), it also has a maximum possible profit – in this case, $5,605.
That sum – the $2.00 difference between the $33.00 and $35.00 strike prices ($10,000), minus the cost of the spread ($0.879, or $4,395) – is the most you can make on this particular trade, regardless of how high the silver futures price might climb by late June.
However, you achieve that profit at any silver futures price above $35.00 an ounce – meaning you need a move of just $1.538 ($35.000 – $33.462 = $1.538) from the current price to make the maximum profit at expiration, easily attainable in this market environment.
Profitable Returns with Silver Options
That maximum profit represents a return of 127.5% on your initial investment - in just over four months.
Plus, if silver makes a large upmove prior to expiration, you can take your profits early and position a new bull call spread using higher strike prices and/or a more distant expiration month.
Table No. 1 shows the profit/loss scenario for this spread at various silver price levels, compared to the profit/loss on the purchase of the futures contract alone.
Be aware, though, that you can easily adjust the risk/reward characteristics of any bull call spread by selecting different option strike prices and widening or narrowing the range between them.
For example, in the above situation, you could have instead purchased the July $33.00 call at $3.451 and sold the July $36.00 call, priced at $2.217 an ounce. That would have given you a spread of $1.234, a maximum possible loss of $6,170 and a maximum possible profit of $8,830 – a potential return of 143.1%.
The choice is yours, based on your own risk/reward preferences.
The strategy is also fully adaptable to any other silver-related investment on which options are available.
For example, if you wanted to trade at a smaller level than the 5,000-ounce futures, you might look at the options on the iShares Silver Trust ETF (NYSEArca: SLV), recent price $32.54.
SLV's price fairly closely tracks actual silver movements, but each option represents just 100 shares. As quoted early this week, that means one July SLV $32.00 call would cost just $355.
To create your bull call spread you could buy 10 of them and simultaneously sell 10 SLV July $36.00 calls, priced at $1.90 ($190).
Doing so, you would create a 1,000-share spread with a total cost and risk of just $1,550 vs. a maximum possible profit of $2,450, as shown in Table 2, giving you a potential return of 158.0%.
Either way, a bull call spread is a good way to maximize your gains on silver while limiting your risk.
Larry D. Spears is a contributing writer for Money Morning.