Turbulent.  Violent.  Ferocious.  Vicious.

These are frightening terms many unsuccessful traders would use to describe their experiences when attempting to trade the Silver futures market.

Due to its large futures contract size – 5000 ounces of Silver per contract and an ever-increasing exchange margin requirement of $11,000+ per contract – traders and brokers have nicknamed Silver “The Widowmaker” for good reason as it seems to have an uncanny knack for punishing traders when they’re wrong, especially when traded irresponsibly by those who are impulsive, stubborn, undisciplined, and overleveraged.

Are you scared yet?

Adding physical silver bullion in the form of coins or bars is a vital component to every investor’s well-diversified portfolio, but that is an entirely different investment enterprise than trading the great white precious metal using leverage in the futures market.

As traders of futures and options on futures, we have to accept that any market can be erratic and unpredictable.  While extreme volatility, exaggerated price spikes, and large daily price ranges are to be fully expected and can be downright nasty, the Silver futures market is not something to fear or run away from.

Rich in history, the lure and appeal of successfully trading Silver, the “Poor Man’s Gold,” continues to attract and tempt a wide and growing variety of traders and investors from every corner of the globe.

GET COMFORTABLE:  ACCEPT RISK & DEFINE YOUR REWARD

If you’re willing to forego the often attempted but rarely achieved consistent daytrading profitability in favor of capital preservation and prudent risk management through the use of Bull Call Option Spreads, you may become a battle-tested trading veteran who would characterize the raging, white-hot Silver market as challenging, yet ultimately highly rewarding…maybe even exhilarating.

The January 2011 consolidation phase or technical correction – a “terrifying” 16 percent cliff dive in less than a month (the white metal boasts an 80%+ gain in 2010) – now appears to have run its course, resolving itself strongly to the upside, back in favor of the long-term bullish uptrend.

Below I will illustrate how you can “strike gold” by taking advantage of this opportunity to get long on the resumption of Silver’s long-term bull trend – in case you didn’t know, its going on 10 years and counting – by putting on a Bull Call Option Spread as it looks to challenge and surpass recent contract highs.

This trading strategy offers bullish traders and investors the opportunity to carefully define both their risk and their reward before deploying capital on the trade.  It allows one to trade the Silver market directionally with prudent money/position management – with the ability to “Get Long” using Silver futures option spreads without exposing your account to a very large exchange margin requirement ($11,000+ per contract) and the always present equity/event risk when holding a futures contract position overnight.

Here is a primer on how a Silver Bull Call Option Spread trading strategy could work for you:

BULL CALL OPTION SPREADS (DEBIT SPREADS) – THE NUTS & BOLTS

The terms bull and call imply a bias toward an upward price direction, so this strategy involves a spread that goes long the market by using call options.  Debit implies that you are paying for the trade and that the costs are being debited from your account.

Some refer to this as a vertical bull call spread.  What is usually involved in this strategy is:  the purchase of a close-to-the money or an in-the-money call and at the same time the sale of a further away strike price (out-of-the-money) call option of the same expiration date (or same expiration month).

The close-to or in-the-money call option may cost a great deal of money as it is near or lower to where the underlying futures contract price is trading, especially if there is substantial time remaining until the option’s expiration.  Traders spread this cost off (or finance it) by selling or writing a further out-of-the-money call option.

When you sell or write a call, you collect premium or receive a credit to your account.  This credit reduces the cost of the close-to or in-the-money call option.

The profit/loss profile for this strategy is a limited risk and a lower expense for the investor as premium costs are reduced (or financed) by the sale of the higher strike price call option.  The short call is covered by the long call, so there is a predetermined risk factored in this trade and no unnecessary risks associated with option writing or selling (aka naked shorts).

The maximum profit potential is limited to the value between the two strike price levels minus the premium costs, the commission, and exchange fees.

SPECIFIC MARKET EXAMPLE – THE STRATEGY:
May Silver 26.25/27.25 Bull Call Option Spread

Let’s review a specific market example:  After hitting a contract high of $31.27 on 1/03/11, near the end of the 1/25/2011 trading session the May Silver market continued trading lower while in the midst of a widely-publicized consolidation phase or technical correction posting a low of $26.575 during this session.  (The daily range on 1/25/11 was LOW:  26.54 to HIGH:  27.04)

For this example, we will use the May Silver 26.25/27.25 call option quote prices taken from floor brokers at the end of the 1/25/11 session.

ENTER THE SPREAD:  GETTING LONG on 1/25/11
(OPTION EXPIRATION DATE:  4/26/11)

BUY 1 May Silver 26.25 Call Option – pay $2.15 premium (-215 cents x $50) =
-($10,750) DEBITED From Cash/Account

SELL 1 May Silver 27.25 Call Option – receive $1.65 premium (+165 cents x $50) =
+$8,250 CREDITED To Cash/Account

NET DEBIT TO ACCOUNT TO BUY/GET LONG THE SPREAD

-$0.50 (-215 cents paid vs.  +165 cents received = -50 cents) =
-($2500.00) PREMIUM PURCHASE PRICE TO ENTER SPREAD

MAXIMUM PROFIT POTENTIAL AT OPTION EXPIRATION

The maximum profit potential is limited to the level between the two strike prices (27.25 – 26.25 = $1.00 or 100 cents x $50/cent = +$5000) minus the premium costs (-$2500), the commission and fees (approximately -$160 per spread at $75/RT/per option and exchange fees.  This would double if the spread is profitable and taken through expiration/converted to futures contracts then offset immediately).

(27.25 Call Strike – 26.25 Call Strike = $1.00 or 100 cents x $50/cent = +$5000) – (-$2500 – $160 or -$2660)
= +$2,340 POTENTIAL PROFIT / 93.6% GAIN PER SPREAD BEFORE COMMISSION/FEES

ULTIMATE OBJECTIVE

The ultimate objective would be for the May Silver futures contract to close above 27.25 on the Option Expiration pit session (4/26/11 @ 12:25pm Chicago Time) to max out the potential profit on this spread.

Upon option expiration, the call options would automatically be converted into long and short futures positions that immediately offset one another (there is no margin risk involved).  The difference between the strikes as described above minus the total cost of the spread or +$2,340 would then be credited as a positive gain back into your account in addition to getting back your original premium paid/trade cost of $2660.

BEST CASE SCENARIO

The best case scenario would be if the May Silver market surges higher than 27.25 at any time prior to option expiration, you can ask your broker to go to the floor to request quotes to find out what the current market value would be to liquidate the position (to sell back or cover the spread).

If we were to attempt to exit/liquidate/sell the spread prior to expiration, to obtain an approximately equal amount of maximum potential profit, the value of the spread would need to be quoted on the floor as Bid @ 100 cents – which is a 50 cent increase from the 50 cent entry/purchase price.

WORST CASE SCENARIO

If the market does not trade higher, you should guard against an erosion of spread premium value by using either a predetermined “mental stop-loss” level based on the futures price and spread quote values or overall loss of capital level and exit the spread, taking a reasonable loss.  Or, the worst case scenario would be the May futures closing on option expiration day below the 1st call strike of 26.25 to allow the spread to expire worthless upon expiration, losing the total premium paid.

TRADE CONCLUSION

On Tuesday 2/08/11, the May Silver market skyrocketed or spiked higher almost an entire dollar in a single session, putting the May Silver 26.25/27.25 Bull Call Spread into very profitable territory.

If one wanted to purchase this spread on the morning of Tuesday 2/08/11, it would cost a trader approximately $4.04 ($20,200) to purchase the May 26.25 Call and they would receive $3.08 ($15,400) by selling the May 27.25 Call.

The difference (or their cost to get long/purchase it) is $4,800 (or 96 cents), which represents the new value of our spread.  It has increased from the 1/25/11 entry price of $0.50 to the current price of $0.96 ($4.04 or -404 cents paid vs.  $3.08 or +308 cents received) = an increase of +$0.46 or $2300 gain to your account (46 cents x $50 per cent).

For all intents and purposes, this spread has nearly reached its maximum potential value at options expiration.  This is an extremely favorable position to be in.  At this point, the spread can (and should) now be liquidated/exited by selling it on the floor.  Or, if you prefer, you could hold the position through to option expiration (EXPIRATION DATE:  4/26/11) if you’re confident that the May Silver price will remain above 27.25.

However, I would strongly suggest placing a Good Till Canceled (GTC) limit order with your broker to use the floor to max out/liquidate or “sell the spread at maximum potential expiration value” as that eliminates your risk exposure, adds positive equity to your account (over +90% gain before commissions/fees), and allows you to refocus and reload for the next trading opportunity.

This is a strategy specifically designed to be somewhat more defensive or “conservatively realistic” in nature.  It did not shoot for the moon (an example of that would be getting long a May 35/40 Bull Call Spread when the market is trading at 20) but allowed you to enter the position relatively “close” to the market with a higher degree of probability for potential success and profitability.

FEAR NOT – EMBRACE OPPORTUNITY

The only thing to fear when using a Bull Call Option Spread is a complete loss of capital paid to purchase the spread.  Since you can clearly define what level of loss you are willing to tolerate in terms of the premium you are willing to pay for the spread, there’s really nothing to fear at all.  You must be comfortable with the risk of loss in any investment or trading endeavor in order to position yourself to reap the reward, if successful.

Bull Call Option Spreads (and conversely Bear Put Option Spreads if you’re bearish on a market) give you the flexibility to trade directionally with the ability to tightly manage risk by constructing how close the spread position is in relation to the market price and where you believe it will trade in the future (ie you can carefully position the strikes to be more defensive or aggressive in nature.  This particular spread example used an In-The-Money Call PURCHASE and an Out-Of-The-Money Call SALE).

This limited risk/limited reward type of trading strategy can be used singularly or even in conjunction with targeted long-term and short-term (intraday/countertrend) futures trades and can offer you a relatively risk averse way to potentially extract profits in the blazing Silver market – especially if you layer in multiple lots and farther out Bull Call Option Spreads (in terms of both price and time).

LEARN MORE ABOUT HOW OPTION SPREADS CAN WORK FOR YOU

If you would like to learn more about how option spread strategies could work for you and your trading, please contact me via the Daniels Trading website.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.