After buying the silver or gold at less than the market value, the big question is, “What if the price goes down before we sell?”
Welcome to the wonderful world of hedging. The term “hedge fund” gets thrown around a lot, but it’s really very simple. A hedge is a position you take to offset risk in another position. A hedge fund is a fund that, theoretically, uses hedges to minimize risk.
Here at Honest Silver and Gold our risk is very well defined. the difference between sales price and purchase price is our profit. Therefore, as the market price of silver or gold declines, so does our profit. In extreme circumstances, this could become negative and translate to a loss! This is something to be avoided.
The question now becomes, “How do we protect from drops in market price?” Fortunately, this has a simple answer: puts. A put is a contract that allows the purchaser of the contract to sell the underlying asset at an agreed-upon price until some expiration date. I realize that can be confusing, so let’s look at an example.
John wants to insure his 100 ounces of silver against loss of market value because silver has hit a high of $45. He buys a put on the open market that has a strike price of $47 and an expiration date 6 months from now. The cost of this put is $5.
John does this because he doesn’t want to lose his profits, so he’s willing to buy this insurance, aka “hedge.”
Let’s see what happens when silver moves in price. If silver drops to $35, his right to sell at $47 is now worth a lot more money. If someone offered you the chance to sell $12 above market value, wouldn’t you take it? Of course you would. So that put that John bought is now worth $12 (or more depending on how much time has passed). His silver dropped by $10, but his put went up by $7. The $3 loss is what John paid for the duration of the insurance. Overall, he reduced his loss to a maximum of $3.
On the other hand, if silver goes up to $55 instead, the picture changes. John’s put will be worth much less, but his silver will have gained $10. Let’s say John holds the put until it expires worthless, he has gained $10 in silver value and lost $5 on his put, for a net gain of $5. In this scenario the put reduced potential profits – that’s the price of insurance.
Now that you understand how a put functions, it’s important to understand how this applies to Honest Silver and Gold, LP. We use puts to protect our purchases until we can sell them. If we buy silver at $35 when the market value is $43 and spend $6 on a put, our worst case scenario is a $2 profit (43 – 35 – 6). Ideally, the silver will be sold as quickly as possible. After the silver is sold, the put can be sold back into the market (Step 4) for close to what we paid for it. This will mean we get the insurance for close to free, maximizing the profit at around $8.