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A Very Interesting Trade

By Theodore Butler

(The following essay was written by silver analyst Theodore Butler. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

I’d like to discuss a recent trade in COMEX silver options, that appears very interesting.

The trade in question is the kind of speculation I occasionally do for myself. Mind you, the last thing I want to do is to encourage folks to speculate in silver. Speculation involves voluntarily embracing extra risk, above and beyond the normal risk of a prudent investment. This is not something most folks are suited for. Besides, the risk/reward ratio in owning real silver is so spectacular, that it is not necessary to juice up the transaction with leverage. But still, this trade caught my attention.

Here are the facts of the trade, then I’ll speculate on what it may mean. On Feb. 27 and 28, what looked to be a single buyer, initiated a purchase of over 6000 call options in the December 2003 option series. About 1500 were bought in the $6 strike price, and over 4500 were done in the $7 strike price. 6000 contracts equals 30 million ounces. The options expire on Nov. 24. The total premium paid, or cost, of the options was about $2 million. In my memory, this was the largest single option transaction in the 20 year history of the COMEX silver options market. Of course, the buyers and sellers are anonymous.

An option, for those not familiar, is a derivatives contract that gives the buyer the right, but not the obligation, to purchase, in the case of a call (or sell in the case of a put), the underlying item, in this instance, a futures contract, at a predetermined price (the strike price) and until a specified date. If the price of the underlying item trades higher than the strike price before the expiration date, it has intrinsic value (the amount above the strike price, or the amount “in the money”) and can be exercised into the underlying item or traded for the amount of the intrinsic value. All options, both in the money, and out of the money (no intrinsic value), have, in addition, a time premium built into the price. This time premium will decay, or evaporate, as the expiration date approaches, reaching zero on or before the expiration date. Entities selling option premium receive the proceeds upfront and get to keep the premium, if the options expires out of the money, and therefore are abandoned by the buyers. If the option trades in the money on or before expiration, the buyer can exercise, or convert, into the underlying item, which the option seller is obligated to provide. Sellers, and I say this only for illustration, are like the house in Las Vegas. Buyers are speculators or are like gamblers, looking to risk money in the hopes of an outsized gain.

Now, let’s speculate on the silver option transaction in question. Who were the entities, both the buyer and the sellers? Most likely, it was an institutional buyer, as there has not been retail participation of this magnitude in COMEX silver options previously. Two million dollars is a big bet that silver will be higher than $6 or $7 by Nov. 24. If silver doesn’t reach those levels by Nov. 24, the sellers keep the buyer’s $2 million. At the $7 strike price, that’s a 50% move from current levels. Even if it is an institutional buyer, it may be that it’s just a straight speculation by someone very bullish on silver (maybe he reads my articles). In that case, there’s not much to be gleaned from the transaction, except what might happen if the trade moves into the money. By the way, it looks like the sellers are the usual entities that sell, or write, premium, since it was the buyer who initiated the transaction.

The speculation gets interesting if the buyer was not speculating, but bought the options as protection against a silver price advance, because of an existing short position. For instance, Barrick Gold comes to mind. This is in the ballpark amount of what they said they were interested in financially settling. Or it could be one of the big concentrated commercials shorts who have been manipulating the silver market for years, and has decided to cover. In any event, since the trade makes sense to me, as a good speculation, it makes extra good sense as price protection to an existing short. While it’s true that $2 million is a lot of money for an out of the money option, if silver crosses $6 or $7 by Nov. 24, it may not be a lot of money when compared to the profit an option position of this size (30 million ounces) could generate. At $10 per ounce, these options would be worth well over $100 million. If silver got to $15 by the end of November, the options would be worth $250 million dollars. Not bad for a $2 million bet. Or a $2 million insurance premium for an existing short.

The main difference between a straight speculation and insurance protection, is that a speculator is likely to take profits and sell at some point, while the trade is likely to be left on longer if it’s insurance protection. No matter the motivation of the buyer, what will happen to the sellers if this trade runs from being deeply out of the money, into being in the money? Or put another way, as I wrote several months ago, did we just witness the passing of the short silver “Hot Potato” of 30 million ounces to the option sellers?

If this trade does make it into the money (above $6 and $7, by Nov.), the option sellers will be in a world of hurt. Right now, at current levels, the exchange minimum margin requirement for each short out of the money call option is no more than $100 each, and maybe much, much less. (In addition to the premium received.) So, the sellers financed their collective short option position of 30 million ounces with an initial deposit of their own money of less than $600,000. If the price of silver crosses the strike prices during the life of the option, the sellers will be required to deposit $300,000 for every penny silver moves above the strike prices, or $30 million for every dollar. Or, they can buy back their short position, which is exactly my point – the financial pressure on these option sellers to buy back their shorts will merciless. The likelihood that these short sales are backed with real silver is almost nonexistent. If silver rises, these option sellers will be forced to buy back at any price. And not just the sellers of these 6000 call options, as there are a total of over 50,000 call options in existence as I write this article. That’s not 30 million ounces held short in COMEX call options, that’s 250 million ounces held short in total. And this 250 million ounce silver call option short position is in addition to the futures total open interest of over 400 million ounces. The 250 million ounce Comex silver call option open interest is separate and distinct from, and in addition to the concentrated short position in futures that I complain to the CFTC and COMEX about regularly. While not all of the total option position is naked or not hedged with other contracts, most are.

My point is that under certain pricing levels of silver, totally unexpected stresses will appear on the silver derivatives landscape. This is not dissimilar to the recent warnings of Warren Buffett about derivatives in general. If this recent option transaction was a transfer, in effect, of the silver short “Hot Potato”, by Barrick or a concentrated short, and we do move into the money on these call options and most silver call options, it will be like dumping rocket fuel on an existing supply and demand fire. Like I said, this was a pretty interesting trade.

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