Oh silver, why must you misbehave so? The only upside to your downside is the inspiration provided for today’s musings. In honor of silver pathetic behavior, I think it’s a good time to flesh out how I feel about cash flow strategies on SLV.
If you’re going to use cash flow strategies like naked puts and covered calls on a stock/ETF, you really only have two choices.
First: Cash flow passively by owning the underlying and selling covered calls or sell naked puts. Do it every month no matter what the chart looks like. I call this the always-on approach.
Second: Cash flow tactically. Only sell puts when an actionable setup develops such as a bull retracement, breakout, or overstretched down. Or, only sell puts when you are bullish on the underlying.
The second approach is more discriminating and rewards a good chart reader. The first method is superior if your chart reading stinks and you want continuous exposure to silver, come hell or high water.
Despite the three letters after my name (CMT) I prefer the first approach. It’s simpler, doesn’t require any prediction, and ensures you don’t miss out on any surprise jumps. Unfortunately, it also guarantees you don’t sidestep any mega-drops either. And that’s part of the reason why this year has been so disappointing. Silver has suffered three substantial swoons.
The saving grace of a cash flow strategy like short puts during times of trouble is supposed to be the premium captured from the consistent selling of options. It generates profit in sideways markets while minimizing, albeit slightly, losses in down markets. You willingly sacrifice upside participation (guaranteeing underperformance in sharp rallies) in exchange for obtaining outperformance during sideways or down markets.
The principle problem I have with SLV is the paltry amount of premium built into its options. Its implied volatility rank has been hovering near 0% for virtually the entire year. And while that may still churn out profits when SLV is consistently trending higher, it leaves virtually no buffer when the ETF starts to fall.
A second takeaway from the low volatility is the difficulty of hedging by selling out-of-the-money calls. My go-to band-aid for ailing naked puts is to sell calls. Typically I sell the same month as the short put and look for a delta around 0.20 or so. It’s been very challenging to do this with SLV.
Say you have some short July $16 or $15.50 puts that you haven’t yet hedged. Which call do you sell here? You can’t sell anything in July because there isn’t any premium available. The Jul $15.50 calls are worth 8 cents, for example. So you have to go to August.
The Aug $16 calls are worth 11 cents here and have a 21 delta. Typically I’d sell this strike, but the 11 cents is altogether uninspiring. How about the Aug $15.50 calls? They have 23 cents which is much better, but the 36 delta is a bit higher than I’d prefer. I want to give SLV room to rebound. It’s currently at $15.08, so perhaps $15.50 is far enough OTM to consider.
The compromise could be to sell some $15.50 calls and some $16 calls. If I’m short ten puts maybe I sell five of one strike and five of the other. These are the challenges that arise when you’re trying to hedge SLV. I don’t have the same difficulties with playing other ETFs.
Admittedly, I probably wouldn’t be as disappointed by SLV if it were rising every month, but that doesn’t negate the fact that its low volatility has really made the life of a premium seller difficult this year.
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