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The Commodity Investor: Active Strategy Employing Silver ETFs Can Tame Metal’s Volatility

Amine Bouchentouf

Credit Suisse follows the January launch of a covered-call gold ETN with a similar silver strategy.

Hedged long positions on certain silver exchange-traded funds, and stop-loss orders can produce shiny returns in a turbulent market.

 

 

Silver has a reputation for being one of the most volatile assets in the commodities complex. In any given period, it’s not uncommon to see silver prices move 10 or 12 percent in a single trading session. In some quarters, prices can fluctuate 40 percent or more, as we saw in the second quarter of 2011.

Silver is so volatile that many market participants claim metal prices are being manipulated by external players. While it’s tough to justify or prove that, the aim of this column is to help you understand the fundamentals of the market and to develop the appropriate trading strategy.

Market Fundamentals

Silver is sometimes known as the schizophrenic metal because of its dual-use applications: It is used in industrial applications as well as for investment purposes. More than 65 percent of silver consumed each year is used for purposes such as industrial piping, engine construction and even in microchips for cameras. The remaining 35 percent is used by investors for trading purposes and as a store of value.

These different market demands may be responsible for silver’s highly erratic price moves. The market responds and is influenced by such different drivers that it’s no surprise we see somewhat regular volatility when it comes to silver. Unlike other metals, silver’s dual uses make it a trickier metal to trade.

For example, gold is primarily used for investment and jewelry purposes, so an analysis of these drivers can help us develop a trading strategy. Similarly, copper is an industrial metal that requires a simple analytic focus on industrial supply and demand.

Silver, on the other hand, has two uses, so we must develop a strategy that looks at two radically different market drivers; this creates an investment countercurrent that triggers volatility.

How To Manage Silver’s Volatility

The best way to invest in silver is to use an active-trading strategy that involves anticipating and picking the right entry and exit points. The price swings can be so violent and unexpected that it’s advisable to have stop-loss orders in place as well. While the strategy should be active, you can use several instruments to trade silver.

The most common silver ETF in the marketplace is the iShares Silver Trust (NYSEArca: SLV). SLV gives you the most basic exposure to physical silver prices determined on the spot market. SLV’s correlation to physical spot prices is 99.1 percent, so it’s a very good proxy for silver prices. My recommendation is to go long SLV, but to have a stop-loss in place just in case the market turns violent, so you can quickly limit your losses.

 

Another interesting ETF you can choose is the Sprott Physical Silver Trust ETV (NYSEArca: PSLV). Just like SLV, PSLV is designed to track silver prices; however, unlike its ETF counterpart, PSLV is a trust designed to hold physical bullion in a vault and does not own silver-backed financial products, only physical silver. PSLV holds a little under 33 million ounces of London Gold Delivery (LGD) silver bars. While the trust's main asset is physical silver, it also keeps a small percentage of its assets in cash equivalents to cover the trust's fees.

Yet another instrument I recommend employing for a more complete trading strategy for silver is the ProShares UltraShort Silver ETF (NYSEArca: ZSL). ZSL allows you to place trades that benefit when silver prices drop. This ETF effectively allows you to short silver prices. This is useful when you have a bearish outlook for silver prices. It’s also a useful tool to use for hedging your long positions.

Let’s say that you’re long SLV, but want to protect your position on the way down and from any potential price volatility. You can simultaneously buy some ZSL so that any drop in your SLV position will be offset by your short. The advantage is that your position will be protected from any downside. However, you will have to give up some gains on the way up as well.

Silver can be a tricky commodity to trade, but there are sufficient trading instruments that, when combined with an active-trading strategy that involves hedged long positions and stop-loss orders, can yield some juicy short-term and long-term returns. Silver is not for the faint of heart, but with the right tools and trading mindset, even this volatile commodity can be tamed.

 

Disclosure: The author doesn’t have any positions in the stocks mentioned.

Amine Bouchentouf is a partner at Parador Capital LLC, an institutional advisory firm focused on commodities and emerging markets. He is the author of the best-selling “Commodities For Dummies,” published by Wiley. Amine is also the founder of Commodities Investors LLC, an advisory firm dedicated to providing insightful information on all things commodities. He can be reached at amine@commodities-investors.com.

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