Forget Oil; This Commodity's Dive Could Make Traders 32%

Jared Levy's picture

Wednesday, December 17, 2014 - 7:30am

by Jared Levy

As analysts debate over when oil prices will find a bottom, crude continues to plunge. While traders are chasing the sell-off in "Texas Tea," there is a perfect bearish storm brewing in another popular commodity. Traders who get positioned now stand to make 32% in the next few months.

While oil officially entered a bear market in October, precious metals have been in a bear market for the past three years. Gold is 38% off its all-time high of $1,923, made in September 2011, while silver has fared even worse. It is down 68% from its April 2011 high just shy of $50.

Given a confluence of factors, the slide in precious metals, and in particular silver, is set to continue through at least the first part of 2015.

Silver Is Not A Safe Haven
Precious metals have long been touted as a safe haven. And in previous decades, investors did move into gold when times got tough in the equity markets. However, over the past 10 years or so, the inverse correlation between gold and stocks has broken down, which was evidenced during the recession of 2008-2009, when investors largely sold gold along with stocks.

Silver provides even less of a safe haven than gold, so it is not likely to be the asset investors move into if global markets and economies continue to slip or even crash.

While silver does have some currency status, it's nothing compared to gold. Unlike gold, silver is not hoarded en masse by governments. And gold is rarer than silver and much easier to store. The yellow metal is about half as dense and worth about 75 times as much at current prices. 

Sensitivity to Industrial Demand

Silver's price is largely influenced by global economic strength. According to the Silver Institute's 2014 World Silver Survey, 54% of silver demand is used in industrial applications such as electronics, computers and solar panels.

Weakness in major industrial silver consumers, including China, Japan and the euro zone, has hurt prices. With China's economic growth rate expected to slow in 2015, Japan entering a recession and myriad problems in Europe, this trend is likely to continue.

Lose-Lose Situation for Silver is U.S.

One correlation that remains intact is the inverse relationship between the U.S. dollar and commodity prices.

On the chart below, we see this played out dramatically between June 2010 and April 2011, as the Dollar Index (red line) dropped while silver (black line) rose to its all-time highs.

SLV vs USD Chart

The U.S. dollar has risen sharply against other major currencies in the past few months, and it is likely to continue to do so as interest rates rise. If the United States remains on its current economic trajectory, the Federal Reserve is expected to begin hiking rates in the first half of 2015.

The Federal Open Market Committee concludes its two-day meeting on Wednesday. Given the recent decline in stocks and oil, investors are not anticipating any announcement regarding an increase in interest rates. However, if policymakers take a more hawkish stance at this or any of the upcoming meetings, we can expect it to serve as a catalyst for a stronger dollar and, conversely, lower silver prices. 

On the other hand, if the economy falters, causing the Fed to keep rates near zero, I think it's safe to say the United States, one of the world's largest consumers of silver, would lose some of its appetite for the metal. 

In short, neither scenario bodes well for silver.

Over the next few months, I'm looking for iShares Silver Trust (NYSE: SLV) to fall to $14, which is 7% below recent prices. Using a put option strategy, we can potentially leverage that move into 32% profits in just four months.

Considering the beating the ETF has taken over the past two days, I expect a bounce in the morning ahead of the FOMC meeting announcement. This should give us a chance to get into the option at an attractive price.

SLV Put Option Trade 

Today, I am interested in buying SLV April 18.50 Puts for a limit price of $3.40.

SLV Call Option
Risk graph courtesy of tradeMONSTER.

This put option has a delta of 90, which means it will move roughly $0.90 for every dollar that SLV moves, but it costs a fraction of the price of the stock. The trade breaks even at $15.10 ($18.50 strike price minus $3.40 options premium.)

If SLV hits my downside target of $14, our put option will be worth at least $4.50. Once you enter the trade, place a good 'til cancelled (GTC) order to sell your puts at that price.

Recommended Trade Setup:

-- Buy SLV April 18.50 Puts at $3.40 or less 
-- Set stop-loss at $1
-- Set price target at $4.50 for a potential 32% gain in four months

Note: Using another put option strategy, my colleague Amber Hestla has a 78 for 78 track record, generating an average annualized return of 43%. To learn how you can start making the same trades today, click here.

This article was originally published on ProfitableTrading.com: Forget Oil; This Commodity's Dive Could Make Traders 32%​

Jared Levy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.