Coal Could Fuel Large Gains for Investors
Coal is back in the news. It seems as if coal has been in the news for the past few years as a flashpoint. There are some who say politicians in Washington declared war on coal. There are others who say that a shift from coal makes economic sense with low natural gas prices. Some simply want good jobs.
When an issue becomes politically charged as coal has, there is a high probability that traders will take notice. Since traders respond to emotional appeals and since coal is emotionally charged, we can expect some volatility among coal producers.
All this passion explains some of the volatility in Peabody Energy Corporation (NYSE: BTU). Peabody is a coal company, which is engaged in the mining of thermal coal for sale primarily to electric utilities and metallurgical coal for sale to industrial customers.
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Its mining operations are located in the United States and Australia. It also markets and brokers coal from other coal producers, both as principal and agent, and trades coal and freight-related contracts through trading and business offices in Australia, China, Germany, India, Indonesia, the United Kingdom and the United States
But, diversified operations couldn’t save the stock from a sell off on news that, “Despite political support from the White House, U.S. coal consumption continues to fall, as power producers shutter coal-fired units in favor of cheaper and more flexible natural gas as well as solar and wind.”
A Long-Term Trend in Demand Is Apparent
Reuters noted, “Electric power producers’ coal consumption fell to 298 million short tons in the first half of 2018, down from 312 million in the same period in 2017, marginally below 2016, and the lowest since 1983 (tmsnrt.rs/2ObCbGz).
U.S. power producers generated almost 6 percent less electricity from coal in the first half of the year even as total generation rose almost 5 percent and gas-fired generation was up 17 percent.
Coal-fired generation declined by 32 billion kilowatt hours in the first six months, while gas-fired generation rose by 89 billion, nuclear was up by 16 billion, solar rose 7 billion and wind was up by 15 billion.
Generators continued to close coal units, with coal-fired generating capacity down to 246 gigawatts at the end of June 2018, compared with 262 gigawatts in June 2017 and 273 gigawatts in June 2016.”
All of this has some ability to explain why coal stocks have struggled. BTU has been trading since April 2017 when the company emerged from bankruptcy. Hope that coal could recover drove the stock up but now hope seems to be fading.
In fact, the brief recovery obscures the long-term trend in coal which is shown in the next chart. Monthly data on Market Vectors Coal ETF (NYSE: KOL) shows that companies in this industry remain almost 70% below their all-time high.
A Trading Strategy to Benefit from Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.
A Bear Call Spread in BTU
For BTU, we could sell an October 19 $36 call for about $1.10 and buy an October 19 $39 call for about $0.30. This trade generates a credit of $0.80, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $80. The credit received when the trade is opened, $80 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $220. The risk can be found by subtracting the difference in the strike prices ($300 or $3.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($80).
This trade offers a potential return of about 36% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if BTU is below $36 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $80 for this trade in BTU.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.