Reasonably Thinking

The Euro continued to stumble down into the $1.20-$1.21 area today as pressures from Spain and Italy mount.  With chatter of a 20th European Summit approaching, I’m willing to take a gain here and consider reentering in the future.  Today, I sold my 2 FXE put options at $6.30, netting me a nice, quick gross profit of $370.  The chart above shows all of my short Euro trades for 2012–sell high and buy low.

Options expiration was today, so I sold my EWP put option (strike of $23) for $1.70.  In May, I originally entered the position positing that financial and/or economic pressures would catch up to Spain, thereby hurting its equity prices.  Although we witnessed some reflections of this as recent as this morning, time decay and transaction costs hurt me on this trade.

As Fed Chairman Ben Bernanke testified to the US Senate today that economic uncertainty had grown, I decided to make an intriguing play on silver.  The transaction is eyebrow raising in two regards:  first, that I made a long investment in silver, and second, in that I employed a four-legged derivative transaction.

Silver is a real asset that can be used for the manufacturing of goods or as an exchange of value (money).  However, its primary use and valuation depends on production, or more broadly, economic demand.  Although a global slowdown is probable, industrial production in the US has been chugging along, and China’s growth rate is still around 7%.

Silver Wheaton SLW

Silver Wheaton is a silver streaming company.  That is, it makes upfront, preproduction payments (investments) for the right to purchase a fixed percentage of future silver production from a mine.  To date, the company has entered into 14 long-term silver purchase agreements and two long-term precious metal purchase agreements, relating to 19 different mining assets, whereby Silver Wheaton acquires silver and gold production from the counterparties for a per ounce cash payment at or below the prevailing market price.

For example, last year, Silver Wheaton’s average silver cash cost per ounce sold was $3.99, whereas its average realized silver price per ounce sold was $34.60.  Likewise, the company’s average gold cash cost per ounce was $300 while realized gold price per ounce sold was $1,609 per ounce.

Management plays a huge role in this business.  Although silver volume and price influence Silver Wheaton’s future, the company is still well positioned.  Many of the company’s investments have already been made, and the company has a respectable operating record.  Furthermore, its mine investments are located in politically stable parts of the world and are aligned with major industry players, such as Barrick ABX and Goldcorp GG.  Teaming with gold miners makes sense since 70% of worldwide silver production comes from copper, lead, zinc, and gold mines.  Hence, Silver Wheaton can take delivery of other miners’ unwanted silver inventory and redistribute it.

A handful of smaller items serve as positives for shareholders:

• Management continues to search for future opportunities as the company has a few small equity stakes in publicly listed mining companies for strategic purposes
• Silver Wheaton maintains a healthy cash position and overly sufficient liquidity ratios
• Shareholders receive a dividend that is linked to operating cash flows, which protects long-term shareholders
• The company is incorporated in the Cayman Islands & Barbados and therefore subject to minimal income tax

Risks to investing in Silver Wheaton center around macroeconomic activity.  If a global slowdown intensifies, demand for silver could wane, bringing down silver prices.  Such a scenario would adversely affect Silver Wheaton.

Derivative Transaction

Today’s transaction consisted of three option legs, all of which expire in January 2014.  I sold 2 puts at $20, bought 1 call at $33, and sold 1 call at $50.  This custom trade enables me to get paid while bearing downside risk and provides upside potential.  This can be thought of in two ways:

• A synthetic long, strike prices of $20 and $33, funded by a cap at $50 and selling an additional put at $20
• A $50/$33 call spread funded by selling two put options at $20

Looking at the chart below, at expiration, I will make $350 if SLW is between $20 and $33.  My gains are positively correlated with SLW, in a linear fashion, up to a share price of $50.  On the downside, my breakeven point is $18.25 per share, at which point I would owe $2 per penny movement below $18.25.

(chart and above analysis account for $45 worth of transaction costs incurred to initiate the three legs)

Initial intake = $350.03

In the past five trading days, the market fell 1.5%.  With the drop, I decided to remove a small short position by covering UPRO at $72.55.  By shorting UPRO last week at $77.36, I earned a quick $102.30 profit.  I am still bearish on equities and will look to recylce this trade if equity valuations trend back up.

To be down on Europe is quite easy these days.  Structurally, the cultures among Eurozone members are quite vast, and the labor market is very rigid.  When employers cannot easily fire workers, they are reluctant to hire workers.  This is a main reason why Spain’s unemployment of younger workers is around 50%.

The European economy is a slump.  A handful of negative new orders readings across Europe hints at declines in production.  Furthermore, the European central bank is unwilling to flood the market with Euros the same way the US & UK authorities have.  All of this points to a weakening currency.  I am also willing to suspect that funds are continuing to leave Eurozone banks in order to find new homes in Swiss, British, or Scandinavian accounts.

With this backdrop, I took a negative position in the Euro by purchasing two put options on FXE, the Euro currency ETF, at a strike price of $126 that expire next month.  Price paid was $4.30 per contract.  In May, I initiated similar futures positions against the Euro on the basis of Greece fears and political infighting.  Although both yielded me quick profits, I am less certain on the timing of this trade and am therefore unwilling apply leverage to this transaction at this time.

Today, I purchased 50 shares of WOOD at $37.26.  This real asset is a core holding.

The appeal of timber is that it is a commodity producing asset, which can be harvested when chosen, and it can be replanted.  Before today, I had zero exposure to timber.

By diversifying with the WOOD exchange traded fund, I avoid company specific risks (even though I don’t expect them) from the major players Rayonier RYN, Weyerhaeuser WY, and Plum Creek Timber PCL.

With the S&P 500 treading near its high watermark, I took advantage of the valuation and shorted 25 shares of UPRO at $77.36.  UPRO is an ETF that performs triple the daily performance of the S&P 500, so by shorting it, I am taking a levered position against the market.

For the past few years, I believed that profit margins have been too high and would eventually revert to their mean, which will bring down earnings.  Although this mean reversion has yet to take place, recent anecdotal evidence of major companies struggling with earnings expectations or same store sales (MCD, PG, NKE) suggest that we may be turning a corner soon.  Even today, Macy’s (M) missed its same store sales expectations. 

With regard to asset allocation, this is a short-term equity trade.  My asset allocation as of 2Q12 can be viewed here.  I look forward to adding another position soon, either shorting equities or taking a long position in real assets.  Top Five is unaffected.

Hey folks, results and commentary for the second quarter is available for viewing at

http://reasonablythinking.com/performance/performance-2q12/

The page features my Recap & Outlook, Asset Allocation, and Performance relative to a Custom Benchmark.  Enjoy.