“Why would anyone want to buy silver or gold, given their failure to rise in this inflationary environment?” We asked this question in the previous version of this report last September. Inflation should have made silver and gold soar. The problem was the strong dollar. By raising interest rates rapidly to combat inflation, the US Federal Reserve made the dollar the only game in town.
We wrote: “The current Fed Funds rate of 2.50% is expected to climb as high as 3.25% soon. Other developed nations are raising their interest rates, but at a far slower pace. The euro area short-term interest rate is currently 0.50% — up from zero a few months ago. This is significantly less than what Europeans can get by turning their euros into dollars and buying American T-bills. A strong greenback tends to drive down the dollar price of precious metals because it takes fewer of them to buy the same amount.”
“High interest rates in the US also increase the opportunity cost of holding precious metals. Gold and silver earn no interest and, since both metals have been falling, investments in bullion have been double losers. We believe this may be changing. The US dollar is extremely overbought and overdue for a significant downward correction, while silver is underpriced and oversold.”
Data Source: Reuters/Datastream
Data Source: Reuters/Datastream
Dollar Bull Damaged
The dollar is overbought and silver is oversold again. However, there are some important differences this time. The dollar was soaring in early September, showing no sign of faltering. Today, it is damaged after falling 12.25 percent from its 114.75 high. 12.25 percent is a huge move in any currency. That it occurred in the globe’s biggest and most important reserve currency is astounding. This move negated the greenback’s uptrend and may have marked the beginning of a new long-term downtrend.
We suggested buying silver in September because we believed the dollar had travelled too far and too fast and was overdue for a major correction. We talked about the dollar “carry trade” and how the huge difference between high US interest rates and everyone else incentivized sophisticated traders to: 1) borrow money at low rates in other currencies, 2) convert those currencies into dollars, and 3) lend those dollars out at much higher rates. It was an easy trade that wound up being too easy.
Silver rose as the dollar fell, hitting our $24.00 per ounce target much sooner than we expected. RMB Group trading customers who followed our suggestion to buy July bull call spreads should have exited their bullish positions once our target was hit. Get ready to enter this market on the long side again. The dollar was the reason for our bullish position in September. And while there is no guarantee that silver will rise in response to a falling dollar again, we believe a continuation of the current downtrend in the buck is reason enough to get long again now.
Fed Forced to Lighten Up?
The Fed led the way in the fight against inflation. However, as we mentioned in our last update, it has a history of doing everything to the extreme. It kept rates too low for too long and will likely keep rates too high for too long. We do not expect the Fed to reduce interest rates until something breaks and comes crashing down. Will it be stocks? Housing? Bonds? High borrowing costs and exploding interest expense from a potential bond market collapse can suck billions from the Federal Government’s operating budget. Big sell-offs in equities and housing precede recessions.
The Fed has raised rates further and faster than we expected. The Fed’s overzealous policies could force it to halt its tightening campaign and, depending on the damage, even reverse course. At the same time, the rest of the world is catching up by raising their short-term interest rates to combat soaring inflation in Europe and virtually everywhere else. The dollar “carry trade” is far less lucrative than it was just months ago after inflicting a world of pain on those who did not exit their long dollar positions in time.
Two things hold silver back now – the corrective rally in the dollar and the expectations for more Fed rate increases. We do not expect the current rally in the dollar to last much longer as the Fed moderates their tightening and the rest of the world plays catch-up. We expect the dollar to resume its slide shortly.
High interest rates mean silver investors are paying high opportunity costs by owning the metal outright. Hard commodities do not pay interest. A holder of $100,000 in silver bullion is giving up interest of nearly $5,000 a year. He or she is also paying to store and insure the metal.
We designed the trade below to provide upside exposure to silver without tying up a lot of cash. High interest rates may be helping the dollar and hurting silver now, but they can also be used to help reduce the cost of the fixed-risk bullish position in silver outlined below. We expect the dollar to suffer and silver to benefit as global interest rates converge.
Use COMEX Call Options to “Rent” Silver for Pennies-on-the Dollar
This strategy is designed to give RMB trading customers upside exposure to silver for a lower cost and risk than purchasing the metal outright, freeing up capital to generate a return somewhere else. Our strategy also insulates holders from the type of volatility that forced many bulls out of the post-Covid silver market.
We use 5,000-ounce COMEX silver options to create our “pennies on the dollar” strategy. Each option covers 5,000 ounces of silver, making each $1.00 per ounce move worth $5,000 and each 1-cent per ounce move worth $50. Buyers of silver call options pay money, known as a “premium,” for the right but not the obligation to be long silver futures at a specific price for a specific period.
Call option buyers do not buy the market; they merely buy the right but not the obligation to be long that market. The key phrase is “but not the obligation.” Should silver decline or fail to rally before the option expires, the option buyer will simply not exercise the right to buy the futures contract. All a silver call option buyer risks is the premium paid, plus any transaction costs.
Silver call option sellers receive money in exchange for the obligation to sell silver futures at a specific price for a certain timeframe. Notice how this definition is the exact opposite of call option buyers. Think of it this way: if you are an employer, you pay money to your employees. This gives you the right to tell them what to do. As an employee, you receive money from your employer, obligating you to do what your employer tells you. Options work the same way.
Combine Long and Short Positions to Reduce Risk
We can lower the cost and risk of our bullish position by combining long silver options with short silver options. Our new upside target on silver is $27.00 per ounce. We want to position ourselves to capitalize on a breakout over silver’s key resistance level of $24.50 per ounce without taking on a lot of undue risk.
One way we can do this is by purchasing a December 2023 Comex Silver call option with a strike price of $24.00 per ounce, while simultaneously selling a December 2023 Comex silver call option with a strike price of $27.00 per ounce. This “bull call spread” pairs the right to buy 5,000 ounces of silver at $24 per ounce with the obligation to sell 5,000 ounces of silver at $27 per ounce.
This spread currently costs $2,600 as of the close on February 24, 2023. Compare this to the roughly $103,800 it currently costs to buy 5,000 ounces of silver outright.
December 2023 COMEX silver options expire on November 27, 2023. This gives us time for the trade to work. We will only lose the amount we pay for this spread plus any related transaction cost should silver fail to be above $24.00 per ounce on this date.
Selling the $27.00 call obligates us to sell silver at $27.00 per ounce, so we cannot participate in any rally above this level. This means the most our bull call spread will be worth is the $3.00 per ounce difference between the two strike prices times the 5,000-ounce contract size or $15,000 – not a bad outcome given our $2,600 (plus transaction cost) risk. Prices can and will change, so contact your RMB Group broker for the latest. Your RMB Group broker will work with you to match a strategy to your risk tolerance and market conditions.
Use Fed Rate Increases to Create Your Own “Silver-Backed” CD
The Fed policy responsible for both the strong dollar and weak silver can also be used to reduce the cost of our bullish silver position. Yields on T-bills and CDs have soared in the past few months. This makes it possible for silver buyers to lower their risk by creating their own “silver-backed” CD. Combine the bull spread strategy above with the purchase of a one-year CD, then use the interest received to help offset the cost of your bull spreads.
For example, Comex 5000 oz. silver futures are currently trading for $20.76 per ounce, making each contract worth $103,800. Instead of buying 5000 ounces of silver bullion or a futures contract, one could purchase a 11-month FDIC-insured CD. A quick search of www.bankrate.com lists a 5-star, Capital One, 11-month CD with an APY of 5.00%. $103,800 invested at 5.00% works out to roughly $4,750 over 11 months. This more than covers the $2,600 cost of our bull call spread.
Please be advised that you need a futures account to trade the options in this report. The RMB Group has been helping its clientele trade futures and options since 1991 and are very familiar with all kinds of option strategies. Call us toll-free at 800-345-7026 or 312-373-4970 (direct) for more information and/or to open a trading account. Or visit our website at www.rmbgroup.com.
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The RMB Group
222 South Riverside Plaza, Suite 1200, Chicago, IL 60606
This material has been prepared by a sales or trading employee or agent of R.J. O’Brien & Associates (“RJO”)/RMB Group and is, or is in the nature of, a solicitation. This material is not a research report prepared by a Research Department. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.
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