Silver Miners Invite a Combination Trade

 | Jun 26, 2013 | 3:00 PM EDT
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Last night, I spent some time poring through options in value stocks. The market has pulled back a touch, and volatility has picked up quite a bit in the past two months. I was searching for candidates for backing into stocks at lower prices by selling puts below the current market price.

I have used this technique countless times and have had a great deal of success, and I'm hoping we get enough of an additional slide in stock prices that I can find several opportunities for cash-secured put-selling. I didn't find much in that area, but I did find some candidates for a long-term combination trade.

A combination trade consists of buying the stock and simultaneously selling out-of-the-money long-term puts and calls. I have used this approach with beaten and battered stocks over the years, and it has produced outstanding success. It works best on stocks that are seeing heavy selling and are enormously and actively out of favor. If you have a deep conviction that the company can survive for the time period covered by the option, this trade can give you as close to a win-win situation as you will ever find on Wall Street.

"Heavily sold" and "actively, wildly out of favor" are terms that pretty much describe the metals miners right now. As Bob Byrne said to me this morning, they are priced as if they are going the way of the buggy whip. Miners are approaching their 2009 lows as metals prices have collapsed. Many of them are selling at huge discounts to their book value. Precious metals have gone from being the darlings of the hard-money crowd to absolute pariahs among traders and investors alike. Every firm on the Street is rushing to follow Goldman Sachs in lowering their gold and silver forecasts.

This sets up some potential trades for long-term aggressive investors who believe that the miners will eventually recover. Lower metal prices are going to force marginal capacity out of the industry, and over time, supply and demand will stabilize. For this trade to work, metal prices do not have to recover back to highs. They just need to not fall to the point where Happy Meal toys are made of gold.

Pan American Silver (PAAS) shares have been brutalized this year. The stock is down almost 40% so far in 2013, and option volatilities have jumped more than 50%. Right now, you can buy the stock around $10.50. You can sell the January 2015 $15 call for $1.05 and the January $10 put for $2.50. That's 33% of what you would pay for the stock. Should the shares trade between $10 and $15 at expiration 17 months from now, you keep the premium for a 23% annualized return, and you still own your shares. If the stock is called away at $15, you make a total of $8.05 for an annualized return of 54%. If the shares fall below $10, you will have to buy more shares at that level, but you get to keep the $2.50. That gives you a net cost average cost of $8.275 for your position. Pan American shares have not traded at that level since 2003, so it would seem to be a decent place to own the stock.

Coeur Mines (CDE) has also been pummeled -- the stock is down 50% so far this year. The company is focusing on domestic mines, so it does not have the same level of political risk that many others miners have had to take on. You can buy the stock right now at around $11.75 and sell the January 2015 $15 call for $1.90 and the $10 put for $1.85. That's about a 22% annualized return if the shares settle between the strikes and 42% annualized if called away at $15. If you end up having to buy more stock, your net cost will be $9 a share, a price not seen since 2009.

Combination trades need several factors to be in place to work correctly. First and foremost, the stock has to be cheap on the basis of fundamentals. I prefer tangible book value, but I have seen price-to-earnings ratios and price-to-free-cash-flow work well. You need to be comfortable owning the stock and delighted to buy more if the stock price keeps falling. The stock should be aggressively unpopular so that there is heavy selling and a rapid rise in option implied volatilities. You should be willing to hold the position at expiration, although there may well be opportunities to trade around or even out of the position during the time frame.

Silver miners seem to fit the bill for a combination trade, and aggressive investors who have a longer time frame might consider adding combination trades on undervalued mining stocks.

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