A stock chart with a line and bar graph overlay
Markets

Profit From Silver's Potential 20% Plunge

With weak economic data and ongoing risks from the Euro zone, fear among market participants has increased dramatically over the past few weeks. The Russell 2000 has lost 9 percent since its intraday high on May 2nd and investors are becoming increasingly concerned that their hard-earned profits could be in jeopardy.

We all know that during a downtrend, it is difficult to keep your portfolio out of the red. However, there are ways to make money in any market, including a market in decline.

How? Simply stated: options. .

Let's use the recent decline in silver as an example.

Recently, Wyatt Investment Research's small cap analyst Tyler Laundon commented on silver's retreat in a letter to subscribers of the Small Cap Investor PRO service as follows:

"Silver has fallen from a high of around $50 to $34 - that's a 30 percent correction. This is not too surprising given that the metal had already soared 60 percent in just over 5 months. It was due to pull back to a level where it wasn't so overbought.

The relative strength indicator (RSI) is showing that silver is an attractive buy right here. An RSI above 70 generally indicates an overbought condition, while an RSI below 30 is oversold...Some technical analysts will say that silver is likely to test its 200-day moving average, which is around $28, before it will establish a new trend.

I think that level would be a gift for silver investors who have been patient and know that averaging into positions is the best way to generate investment returns over the long-term.

I believe that we'll see silver's volatility mellow out in the coming sessions, and that it will begin to consolidate after a heck of a run. Even if that is around $33, it would still be a 10 percent gain in 2010 - very respectable."

So, if Tyler is indeed correct and silver trades sideways, potentially bottoming out around $28 how can we make money while SLV loses or remains range-bound?

There are quite a few options strategies that we could use, but for simplicity's sake I am going to sell vertical put spreads.

Here is a potential trade using the highly liquid iShares Silver Trust (NYSE: SLV) .

If you agree with Tyler's analysis you could sell the following vertical put spread or bull put spread.

- Sell to open Aug11 SLV 28 puts

- Buy to open Aug11 SLV 26 puts for a total credit of $0.18 or a return of 9 percent .

Silver could fall roughly $7 or 20 percent and you would still make a 9 percent return on this trade. Of course, as with every investment there are disadvantages. Basically, you will make money unless SLV plummets over the next 60 days, when the contracts expire.

Commission costs increase because there are essentially two open positions as opposed to one with the stock and that the credit you receive for the trade is much smaller than the max risk of the trade, therefore it is always prudent to close the short option before the position is at a max loss.

If this all sounds confusing then please do not hesitate to email me at editorial@smallcapinvestor.com -- I would be more than happy to answer any of your questions regarding all things options.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

Stocks

Latest Markets Videos