Hedging Against Falling Silver Prices using Silver Futures

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Contents

Hedging Against Falling Silver Prices using Silver Futures

Silver producers can hedge against falling silver price by taking up a position in the silver futures market.

Silver producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of silver that is only ready for sale sometime in the future.

To implement the short hedge, silver producers sell (short) enough silver futures contracts in the futures market to cover the quantity of silver to be produced.

Silver Futures Short Hedge Example

A silver mining firm has just entered into a contract to sell 3.00 million grams of silver, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of silver on the day of delivery. At the time of signing the agreement, spot price for silver is JPY 30.23/gm while the price of silver futures for delivery in 3 months’ time is JPY 30.00/gm.

To lock in the selling price at JPY 30.00/gm, the silver mining firm can enter a short position in an appropriate number of TOCOM Silver futures contracts. With each TOCOM Silver futures contract covering 30,000 grams of silver, the silver mining firm will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the silver mining firm will be able to sell the 3.00 million grams of silver at JPY 30.00/gm for a total amount of JPY 90,000,000. Let’s see how this is achieved by looking at scenarios in which the price of silver makes a significant move either upwards or downwards by delivery date.

Scenario #1: Silver Spot Price Fell by 10% to JPY 27.21/gm on Delivery Date

As per the sales contract, the silver mining firm will have to sell the silver at only JPY 27.21/gm, resulting in a net sales proceeds of JPY 81,621,000.

By delivery date, the silver futures price will have converged with the silver spot price and will be equal to JPY 27.21/gm. As the short futures position was entered at JPY 30.00/gm, it will have gained JPY 30.00 – JPY 27.21 = JPY 2.7930 per gram. With 100 contracts covering a total of 3000000 grams, the total gain from the short futures position is JPY 8,379,000

Together, the gain in the silver futures market and the amount realised from the sales contract will total JPY 8,379,000 + JPY 81,621,000 = JPY 90,000,000. This amount is equivalent to selling 3.00 million grams of silver at JPY 30.00/gm.

Scenario #2: Silver Spot Price Rose by 10% to JPY 33.25/gm on Delivery Date

With the increase in silver price to JPY 33.25/gm, the silver producer will be able to sell the 3.00 million grams of silver for a higher net sales proceeds of JPY 99,759,000.

However, as the short futures position was entered at a lower price of JPY 30.00/gm, it will have lost JPY 33.25 – JPY 30.00 = JPY 3.2530 per gram. With 100 contracts covering a total of 3.00 million grams of silver, the total loss from the short futures position is JPY 9,759,000.

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In the end, the higher sales proceeds is offset by the loss in the silver futures market, resulting in a net proceeds of JPY 99,759,000 – JPY 9,759,000 = JPY 90,000,000. Again, this is the same amount that would be received by selling 3.00 million grams of silver at JPY 30.00/gm.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the silver seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling silver prices while still be able to benefit from a rise in silver price is to buy silver put options.

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Valuing Common Stock using Discounted Cash Flow Analysis

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Hedging Against Rising Silver Prices using Silver Futures

Businesses that need to buy significant quantities of silver can hedge against rising silver price by taking up a position in the silver futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of silver that they will require sometime in the future.

To implement the long hedge, enough silver futures are to be purchased to cover the quantity of silver required by the business operator.

Silver Futures Long Hedge Example

A silverware company will need to procure 3.00 million grams of silver in 3 months’ time. The prevailing spot price for silver is JPY 30.23/gm while the price of silver futures for delivery in 3 months’ time is JPY 30.00/gm. To hedge against a rise in silver price, the silverware company decided to lock in a future purchase price of JPY 30.00/gm by taking a long position in an appropriate number of TOCOM Silver futures contracts. With each TOCOM Silver futures contract covering 30000 grams of silver, the silverware company will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the silverware company will be able to purchase the 3.00 million grams of silver at JPY 30.00/gm for a total amount of JPY 90,000,000. Let’s see how this is achieved by looking at scenarios in which the price of silver makes a significant move either upwards or downwards by delivery date.

Scenario #1: Silver Spot Price Rose by 10% to JPY 33.25/gm on Delivery Date

With the increase in silver price to JPY 33.25/gm, the silverware company will now have to pay JPY 99,759,000 for the 3.00 million grams of silver. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the silver futures price will have converged with the silver spot price and will be equal to JPY 33.25/gm. As the long futures position was entered at a lower price of JPY 30.00/gm, it will have gained JPY 33.25 – JPY 30.00 = JPY 3.2530 per gram. With 100 contracts covering a total of 3.00 million grams of silver, the total gain from the long futures position is JPY 9,759,000.

In the end, the higher purchase price is offset by the gain in the silver futures market, resulting in a net payment amount of JPY 99,759,000 – JPY 9,759,000 = JPY 90,000,000. This amount is equivalent to the amount payable when buying the 3.00 million grams of silver at JPY 30.00/gm.

Scenario #2: Silver Spot Price Fell by 10% to JPY 27.21/gm on Delivery Date

With the spot price having fallen to JPY 27.21/gm, the silverware company will only need to pay JPY 81,621,000 for the silver. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the silver futures price will have converged with the silver spot price and will be equal to JPY 27.21/gm. As the long futures position was entered at JPY 30.00/gm, it will have lost JPY 30.00 – JPY 27.21 = JPY 2.7930 per gram. With 100 contracts covering a total of 3.00 million grams, the total loss from the long futures position is JPY 8,379,000

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the silver futures market and the net amount payable will be JPY 81,621,000 + JPY 8,379,000 = JPY 90,000,000. Once again, this amount is equivalent to buying 3.00 million grams of silver at JPY 30.00/gm.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the silver buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising silver prices while still be able to benefit from a fall in silver price is to buy silver call options.

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Writing Puts to Purchase Stocks

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Bull Call Spread: An Alternative to the Covered Call

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Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

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Understanding Put-Call Parity

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An Introduction To Trading Silver Futures

After gold, silver is the most invested precious metal commodity. For centuries, silver has been used as currency, for jewelry, and as a long term investment option. Various silver-based instruments are available today for trading and investment. These include silver futures, silver options, silver ETFs, or OTC products like mutual funds based on silver. This article discusses silver futures trading—how it works, how it is typically used by investors, and what you need to know before trading.

The Basics

To understand the basics of silver futures trading, let’s begin with an example of a manufacturer of silver medals who has won the contract to provide silver medals for an upcoming sports event. The manufacturer will need 1,000 ounces of silver in six months to manufacture the required medals in time. He checks silver prices and sees that silver is trading today at $10 per ounce. The manufacturer may not be able to purchase the silver today because he doesn’t have the money, he has problems with secure storage or other reasons. Naturally, he is worried about the possible rise in silver prices in the next six months. He wants to protect against any future price rise and wants to lock the purchase price to around $10. The manufacturer can enter into a silver futures contract to solve some of his problems. The contract could be set to expire in six months and at that time guarantee the manufacturer the right to buy silver at $10.1 per ounce. Buying (taking the long position on) a futures contract allows him to lock-in the future price.

On the other hand, an owner of a silver mine expects 1,000 ounces of silver to be produced from her mine in six months. She is worried about the price of silver declining (to below $10 an ounce). The silver mine owner can benefit by selling (taking a short position on) the above-mentioned silver futures contract available today at $10.1. It guarantees that she will have the ability to sell her silver at the set price.

Assume that both these participants enter into a silver futures contract with each other at a fixed price of $10.1 per ounce. At the time of expiry of the contract six months later, the following can occur depending upon the spot price (current market price or CMP) of silver. We will walk through several possible scenarios.

In all the above cases, both the buyer/seller achieves buying/selling silver at their desired price levels.

This is a typical example of hedging—achieving price protection and hence managing the risk using silver futures contracts. Most futures trading is intended for hedging purposes. Additionally, speculation and arbitrage are the other two trading activities which keep the silver futures trading liquid. Speculators take time-bound long/short positions in silver futures to benefit from expected price movements, while arbitrageurs attempt to capitalize on small price differentials that exist in the markets for the short term.

Real World Silver Futures Trading

Although the above example provides a good demo to silver futures trading and hedging usage, in the real world, trading works a bit differently. Silver futures contracts are available for trading on multiple exchanges across the globe with standard specifications. Let’s see how silver trading works on the Comex Exchange (part of the Chicago Mercantile Exchange (CME) group).

The Comex Exchange offers a standard silver futures contract for trading in three variants classified by the number of troy ounces of silver (1 troy ounce is 31.1 grams).

  • full(5,000 troy ounces of silver)
  • miNY (2,500 troy ounces)
  • micro (1,000 troy ounces)

A price quote of $15.7 for a full silver contract (worth 5,000 troy ounces) will be of total contract value of $15.7 x 5,000 = $78,500.

Futures trading is available on leverage (i.e., it allows a trader to take a position which is multiple times the amount of the available capital). A full silver futures contract requires a fixed price margin amount of $12,375. It means that one needs to maintain a margin of only $12,375 (instead of the actual cost of $78,500 in the above example) to take one position in a full silver futures contract.

Since the full futures contract margin amount of $12,375 may still be higher than some traders are comfortable with, the miNY contracts and micro contracts are available at lower margins in equivalent proportions. The miNY contract (half the size of the full contract) requires a margin of $6,187.50 and the micro contract (one-fifth the size of a full contract) requires a margin of $2,475.

Each contract is backed by physical refined silver (bars) which is assayed for 0.9999 fineness and stamped and serialized by an exchange-listed and approved refiner.

Settlement Process for Silver Futures

Most traders (especially short term traders) usually aren’t concerned about delivery mechanisms. They square off their long/short positions in silver futures in time prior to expiry and benefit by cash settlement.

The ones who hold their positions to expiry will either receive or deliver (based on if they are the buyer or seller) a 5,000-oz. COMEX silver warrant for a full-size silver future based on their long or short futures positions, respectively. One warrant entitles the holder the ownership of equivalent bars of silver in the designated depositories.

In the case of miNY (2,500-ounce) and micro (1,000-ounce) contracts, the trader either receives or deposits Accumulated Certificate of Exchange (ACE), which represents 50 percent and 20 percent ownership respectively, of a standard full-size silver warrant. The holder may accumulate ACE’s (two for miNY or five for micro) to get a 5,000-ounce COMEX silver warrant.

Role of the Exchange in Silver Futures Trading

Forward trading in silver has been in existence for centuries. In its simplest form, it is just two individuals agreeing on a future price of silver and promising to settle the trade on a set expiry date. However, forward trading is not standard. It is therefore full of counterparty default risk. (Related: What Is the Difference Between Forward and Futures Contracts?)

Dealing in silver futures through an exchange provides the following:

  • Standardization for trading products (like the size designations of full, miNY or micro silver contracts)
  • A secure and regulated marketplace for the buyer and seller to interact
  • Protection from a counterparty risk
  • An efficient price discovery mechanism
  • Future date listing for 60 months forward dates, which enables the establishment of a forward price curve and hence efficient price discovery
  • Speculation and arbitrage opportunities that require no mandatory holding of physical silver by the trader, yet offer the opportunity to benefit from price differentials
  • Taking short positions, both for hedging and trading purposes
  • Sufficiently long hours for trading (up to 22 hours for silver futures), giving ample opportunities to trade

Market Participants in the Silver Futures Market

Silver has been an established precious metal in dual streams:

• It is a precious metal for investment

• It has industrial and commercial uses in many products

This makes silver a commodity of high interest for a variety of market participants who actively trade silver futures for hedging or price protection. The major players in the silver futures market include:

How Are Futures Used to Hedge a Position?

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price.

The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this can be impossible. Therefore, individuals attempt to neutralize risk as much as possible instead. Here, we dig a little bit deeper into using futures to hedge.

Key Takeaways

  • Futures contracts allow producers, consumer, and investors to hedge certain market risks.
  • For instance, a farmer planting wheat today may sell a wheat futures contract now. He will then buy it back come harvest when he sells his wheat – effectively locking in today’s price and hedging away market fluctuations between planting and harvest.
  • Because futures contracts often require actual delivery of the underlying at expiration, hedgers must be sure to exit or roll over positions before expiry.

Using Futures Contracts to Hedge

When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company’s risk because it will be able to close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. As an example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells.

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.

Sometimes, if a commodity to be hedged is not available as a futures contract, an investor will instead seek out a futures contract in something that closely follows the movements of that commodity, for example buying wheat futures to hedge the production of barley.

Tips For Hedging Silver

[Editor’s Note: Silver – like gold – has enjoyed a high-octane surge. But what now? How do you keep chasing the profits that inflation is sure to bring without risking the loss of those profits should silver prices reverse? Well, options expert Larry D. Spears last week showed investors how to hedge against a possible decline in the price of gold – and this week he’s back to do the same with silver.]

By Larry D. Spears , Contributing Writer , Money Morning • March 17, 2020

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Gold has gotten a lot of attention recently, as the yellow metal earlier this month rose to yet another record high. However, gold’s little brother – silver – shouldn’t be forgotten.

Although gold has garnered most of the headlines – thanks primarily to its historic role as a hedge against both inflation and the political turmoil – silver has actually turned in a far more impressive performance since mid-2020.

In fact, the silver futures contract calling for May 2020 delivery – traded on the Comex division of Chicago’s CME Group Inc. (Nasdaq: CME) – has risen more than four times as much as gold over the past seven months.

To be precise, after closing at $18.117 per ounce on July 30, 2020, the May future (SIK11) climbed steadily to $34.780 an ounce at the close of trading on Tuesday, March 1, a gain of $16.663 an ounce, or 91.97%.

Since each Comex silver futures contract represents 5,000 ounces of silver – meaning each one-cent move in the price is worth $50 – that translates to a profit of $83,315.

Again, that’s in just seven months.

By contrast, April Comex gold futures (GCJ11) rose just 20.59% over the same period – climbing from $1,186.80 an ounce at the end of July 2020 to a record-high $1,432.20 per ounce at the close on March 1. On the 100-ounce futures contract, that increase of $245.40 an ounce translates to a profit of $24,540 – impressive, but far short of the numbers posted by silver.

So, if you were one of the investors astute enough to catch the full ride in silver – or if you’re just sitting on a sizeable gain in the white metal – what should you do now?

Well, it may be time to start protecting your profits by hedging against a potential decline.

Hedging Silver

Given the size of silver’s advance, a pullback seems inevitable – despite the Middle East unrest and related specter of inflation linked to rising prices for oil and other commodities.

There are three ways to hedge against a potential decline.

The first and most obvious choice ­- if you hold silver futures or a sizable quantity of physical silver – would be to use the same strategy detailed in our earlier story on hedging gold profits. In other words, you can “insure” your gains by purchasing one at-the-money put option for each “long” silver futures contract you hold (or for the equivalent amount of silver coins or bullion).

The only problem with this approach is that the dramatic rise in silver prices has caused an equally sharp jump in silver option premiums. For example, based on the March 1 closing price of $34.780 for the May silver future, the price for the at-the-money May $35.00 Comex silver put option settled at $2.236 per ounce – or $11,180 for the full 5,000-ounce contract.

That’s a hefty premium to pay for an insurance policy that will only last about a month and a half (the May 2020 silver options expire on Tuesday, April 26) – and it doesn’t even provide that much protection. To wit, the price of the May future would have to fall to $32.764 (the $35.00 strike price minus the $2.236 option premium = $32.764) before the insurance would even kick in, which would cost you $10,080 of your current profits.

That’s not the most attractive scenario at this stage of the game – especially for a futures position, where a stop-loss order would likely work just as well.

The second way to hedge against a decline in silver would be to use the out-of-the-money May $34.00 put, which was priced at $1.696 per ounce ($8,480) at the close of March 1. With that option, the insurance would kick in at a futures price of $32.304, meaning you’d give back $12,380 in profits before you gained any offsetting protection.

Of course, that’s not much better than our first option.

Fortunately, there’s a third way to structure an option hedge that’s perfect for a situation like this. It uses three options instead of just one – and, in most cases, it can be positioned at little or no net cost.

I’m talking about a “Three Legged Options Hedge.”

The Best Way to “Insure” Your Silver Gains

Let’s review the circumstances again to set the stage for an example.

At the market close on March 1, the May Comex silver future was priced at $34.780 per ounce, giving those who bought in mid-2020 a profit of around $80,000. Although economic and market conditions seem generally bullish, there’s always the risk of a price pullback in the two months before the future comes due for delivery, and high option premiums make a traditional “insurance” hedge using put options prohibitively expensive – especially since you’d have to give back $10,000 to $12,000 in profits before it even provided any protection.

However, unlike gold, which is driven largely by investor emotions and can thus make really big moves in a short period of time, silver has some restraining factors that make a huge short-term drop unlikely.

Although it hasn’t been used in U.S. coins since 1965, silver is still viewed as an attractive investment – especially among those who can’t afford gold – and it’s in high demand as an industrial commodity, being utilized in jewelry-making, photographic processes and the manufacture of various electronics products. It’s also much more difficult to recycle than gold, impacting the supply side and providing a further prop for prices.

As a result, you think it’s unlikely a short-term silver correction would cover more than $2 to $3 an ounce – and you also feel that, given the strong advance already, any price gains between now and May would be similarly limited.

So, you decide to position a three-legged option hedge that will protect against a drop of that size while still allowing you to profit should prices move modestly higher before May. Here’s what you’d do, using the futures and options prices quoted at the market close on March 1:

  • Hold your May Comex silver futures contract, currently priced at $34.780 per ounce, making it worth $173,900.
  • Buy a May silver put option with an at-the-money strike price of $34.50, which was priced at $1.953 per ounce, meaning it would cost a total of $9,765. (Note: For simplicity’s sake, we’re ignoring commissions – but they shouldn’t run more than $15 per option at the most.)
  • Offset part of your cost for the $34.50 put by selling an out-of-the-money May $32.00 put option, which was priced at $0.905, or $4,525 for the full contract. There would be no margin requirement for the sale of this option since it would be “covered” by your long $34.50 put with its higher strike price.
  • Offset nearly all of the rest of the cost of the $34.50 put by selling an out-of-the-money May $37.00 call option, which was priced at $0.986, or $4,930 for the full contract. Again, there would be no margin requirement for this sale since the short call option would be “covered” by the long futures contract.

The end result is a three-pronged option hedge – positioned at a net cost of just $310 ($9,765 – $4,525 – $4,930 = $310) – that would have the following characteristics:

  • Your maximum loss on any downward move in the May silver futures price would be absolutely limited to $1,710 – until the price dropped below the $32.00 strike price of the put you sold. After that, the loss would mount at the same pace as the loss on the futures contract, though your net overall loss would always be $12,190 less than the loss on the future alone, regardless of how far prices fell.
  • You would add to your profits on any upward move in the May silver futures price – though your profit would be $310 less than on the future alone, reflecting the net cost of the hedge.
  • You would reach a maximum additional profit of $10,790 once the futures price went above the $37.00 strike price of the call option you sold. After that, you would lose out on any additional profit because losses on the short call you sold would offset gains on your long futures contract.

In summary, your hedge would cost $310, give you a maximum additional profit of $10,790 at any futures price above $37.00 an ounce, and limit your loss to just $1,710 so long as the futures price didn’t go below $32.00 an ounce.

For a look at the potential outcomes of this hedge at various silver prices – both higher and lower – check out the accompanying table. (Note: The top line shows the opening values of the hedge and the results shown assume the positions are held until the options expire.)

Be aware, however, that you are under no obligation to hold the initial hedge until expiration. If prices move substantially in either direction, you can “roll” the options to higher (or lower) strike-price levels, thus adjusting the profit/loss parameters of the hedge.

Should late April arrive and you think silver is still headed higher, you can also roll your entire position to a futures delivery month later in the year – say July, September or December – positioning a new options hedge with the appropriate strike prices at the time. (Note: The expiration dates for the July, September and December silver options are June 27, August 25 and November 22, respectively.)

If you’ve made your silver investment using mining stocks, the same triple-pronged hedge will work with them if they have listed options, though very few pure-play silver stocks are traded on U.S. exchanges. In addition, a simple put-purchase hedge may prove cheaper and easier to implement with an individual stock than with the much higher-valued futures contracts.

Fund investors also can use either strategy to hedge their holdings in the five U.S.-listed, silver-oriented exchange-traded funds (ETFs) on which options are traded – two examples being the iShares Silver Trust Fund (NYSE: SLV) and the PowerShares DB Silver Fund (NYSE: DBS).

Be aware, however, that two of the funds – the ProShares Ultra Silver ETF (NYSE: AGQ) and the ProShares UltraShort Silver ETF (NYSE: ZSL) – use leverage to produce price moves double the size of spot silver changes, so the hedging effects will need to be adjusted.

(Note: ZSL is also an “inverse” fund, meaning its share prices rise when silver prices fall. As such, its shares can actually be purchased to hedge against declines in silver prices – but that’s another story entirely.)

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