Honest Silver and Gold

No discussion of financial matters would be complete without discussing risks. We are putting money at stake, and no matter what hedges or precautions are put in place, it is always possible to lose money. While unlikely, here are some risks that come to mind:

1. Buying fake silver/gold. All purchases are tested to avoid this, but tests could be wrong.
2. The options exchange crashes. It is possible that the market in which we buy and sell the put hedges could crash. If we have a position open at that time, this would have a profound effect on the price or marketability of our hedge.
3. Shipping theft. All shipments will be insured to address this, but insurance could be stalled/denied.
4. Market volatility drops precipitously. The price of our put depends partly on the volatility of the silver or gold. If silver or gold suddenly flatlines, the put will be worth less no matter what the actual price is.

I will add to this list over time as more risks become known. If you have a question about a risk and would like to see it addressed here, post a comment below.

Incidentally, there is something that sounds like a risk but isn’t. If the paper funds (mainly SLV and GLD) are proved to not have the assets that are claimed, then this will actually be very good. The SLV/GLD price will plummet while the price of physical metal will increase. Both the hedge and the bullion would increase in value!

I just read an opinion piece over at Zero Hedge called Physical Silver Investors are Being Hoodwinked by the Futures Market. In this article, the author basically makes the point that silver prices are being run up by speculators in the paper markets. As things are run up, so are the primed for a run down.

Only time will tell if Mr. Chu is correct or not. I tend to doubt it, personally. What I do not doubt though is that commodities, and especially silver, are very volatile. It is against this up or down that we protect our positions with puts. Let’s say one day the world wakes up and discovers that silver is in fact no good for anything, and the price plunges to $2. That’s OK, our puts will gain in value as the silver loses value.

That’s the purpose of hedging: to offset risk.

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.

This post will explain the fundamental process of how Honest Silver and Gold, LP turns silver and gold into cash flow. Honest Silver and Gold is about, well… honesty. So there are no tricks or diversions here. Just these basic steps:

Step 1: Buy silver and/or gold at under the current market value.

Step 2: Buy long-dated (4+ months to expiration) puts

Step 3: Sell the silver/gold at close to market value

Step 4: Sell the puts back into the market

Step 5: Profit

That’s all there is to it! Of course, the devil is in the details, so each one of these steps will be discussed individually as to how it is achieved.