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David Hill's Analyst Insights

Options and ETF Analyst Writer
David G. Hill
Author Bio

August 27, 2012 - Can a Bearish Metals Play be a Golden Trade?

As we mentioned last week, there was no shortage of losers in the latest round of corporate earnings. The S&P 500 posted its weakest quarter of growth since 2009, and it is easy to pick out which industries are the laggards. Chief among them is the metals and mining industry. A majority of the mining stocks in the S&P 500 posted earnings below forecasts in the last month and a half. Many of the biggest miners disappointed investors this earnings season, most notably BHP Billiton (BHP). The mining company (the largest in the world) beat analyst estimates with a $5.5 billion first-half profit, but announced it will shelve $68 billion worth of projects due to falling metal prices and rising costs.

BHP?s hugely cautious maneuvering reflects the trouble facing the overall metals industry. Copper titan Freeport McMoRan (FCX) beat estimates when it reported earnings last month, but also cut its full-year copper production forecast in the wake of falling prices. The company received $3.53 per pound of copper during the second quarter, down from $4.22 per pound a year ago. Because copper is used in electronics manufacturing and construction, the falling price reflects the slowdown in global economic growth.

Such is the case for a wide variety of basic materials. Steelmaker Nucor (NUE) missed earnings estimates and forecast a decline in third-quarter earnings due to weakening demand domestically and internationally. Competitor US Steel (X) beat forecasts in its second-quarter report, but also noted that its shipments fell 4.1% compared to the first quarter. This is a bit of a bad sign, since the second quarter is typically the busiest time of the year for steelmakers. In a conference call, US Steel CEO John Surma said, "The global economic recovery continues to be slow and unsteady and we have focused on finding ways to make money in the economy we have today." That is hardly optimistic.

As a result, the stock prices of key metal stocks have been in relative freefall since February, as evidenced by the performance of the SPDR S&P Metals and Mining ETF (XME). Normally, this is a good signal for bargain hunters, who can pounce on a beaten-down ETF in expectation that it will soon recover. But using options, we can construct a trade on this ETF that will profit even if it continues to fall (within limits ? see below). As an added bonus, a two-legged options trade requires less capital than a simple bargain-hunting purchase.

Consider a December 48/50 bear-call spread on XME for a net credit of around $0.30. This is good for a 17.6% return (54.1% annualized ? for comparison purposes only). XME is roughly 11.2% out of the money, and this trade has a breakeven point of $48.30 with 11.9% protection.

XME is showing neutral technicals with support at 41.21 and resistance near 42.52. Standard & Poor?s gives the ETF a Marketweight rating. Of the ETF?s top ten holdings, S&P rates one at Strong Buy (Reliance Steel), three at Buy (Commercial Metals Co., US Steel, and Carpenter Technology), three at hold (Arch Coal, Steel Dynamics, and CONSOL Energy), and one at Sell (Nucor). Two of the ETF?s top ten holdings (Schnitzer Steel and Cloud Peak Energy) are not covered by S&P.

To get a 17.6% return on a simple long position on XME, the ETF would have to rise to $50.76, a level it has not even sniffed since early April. To make that kind of return on a short-sale of XME, the ETF would have to fall to $35.54, lower than even the 52-week low the ETF set in July. XME bounced off of support in the $38 range in July, but seems to have found new resistance around $43.

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