Friday, December 21, 2012

Morning Update

Last night Speaker Boehner scraped the House’s vote on “Plan B” because there were not enough Republican votes to pass it. This sent stocks around the world tumbling and a heavy dose of risk aversion in currency markets. S&P 500 futures lost about 50 points in a matter of minutes but has since stabilized higher and are down 22 ahead of the open. The US dollar and Yen as also stronger this morning as trader s move into safe haven assets. The VIX is the real mover on the news and the Jan future is up over 7%. Speaker Boehner is expected to speak at 10 EST and could give the market a clue as to his next move. The good news out of the Plan B failure is that everyone, especially the President, knows which Republicans will not compromise on tax increases, whether Boehner wants them or not. Boehner will have to tell Obama that if he wants a bill he will have to rally Democrats to meet the Republics that are willing to compromise half way. However, if Obama cannot get Democrats to compromise or Boehner loses too many additional votes on a compromise bill the US is likely to go off the cliff.

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 many traders perplexed. Typically silver, like gold, is seen as an inflation hedge and would be expected to appreciate after the Fed announced it would increase its asset purchase 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 where funds are buying riskier high-yield debt and selling metals, which yield nothing but are safe havens. We also suspect there has been short term pressure on the metals due to end of the year profit taking and fund liquidation.

Yesterday one trader sold a Jan. 29 call and put in SLV, the physical silver ETF, for a net credit of $1.55. This trade is a bet that silver will remain range bound between 27.45 and 30.55 (+/- 5%) over the next 28 days. Our models suggest gold and silver are near their fair value at current levels, and expect only a few percent in 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 which means that there is more premium to be collected by selling options. Of course with more potential reward comes more risk, and silver has been known to move over 3% on a daily basis.

While I like the idea of betting on range bound silver, I think this trade, with unlimited risk in both directions is too risky. Because I am mildly bullish on metals here I prefer a covered call position where you are long the ETF and short an at the money call. This position will profit if silver remains range bound to up, and will have limited risk on the downside.

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