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Time to Look at a Beaten Down Commodity

Time to Look at a Beaten Down Commodity

Commodities have struggled for the past several years as traders seem to struggle to make sense of the economic news. Among the most confusing sources of news are two countries that exert a strong influence on the price of iron ore and other commodities.

China is a source of frequent confusion for traders. There is always hope that China’s economy will deliver strong growth and drive the global economy higher. But, occasionally the short term news brings disappointment and speculation that growth is slowing.

Brazil is another source of frequent hope and disappointment. Investors hope the country will be able to overcome frequent political turmoil to deliver steady economic growth. This is especially important because of Brazil’s position in the global economy as a large commodity producer.

A Stock Turning Up With Commodity Prices

Hope that both countries will deliver good news, at least in the short run, led to gains in Vale S.A. (NYSE: VALE). The stock’s recent rally is shown in the chart below.

Vale S.A. is a global leader in the production and sale of iron ore and iron ore pallets for steelmaking in Brazil and internationally. Its Ferrous Minerals segment produces and extracts iron ore and pellets, manganese, ferroalloys, and others ferrous products and services, as well as engages in the provision of railroad, port, and terminal logistics services.

Iron ore is an integral part in industrial use and crucial to economic well-being. This metal’s value lies in its role as a vital ingredient for making steel used in construction, infrastructure, machinery, appliances, transportation, energy generation and many other markets.

Dependence on steel and iron ore has made the global economy highly susceptible to changes in the price of iron ore and factors that affect the supply and demand of the ore. These factors also contribute to the volatility of producers like VALE.

The International Monetary Fund (IMF) expects economic growth of 3.6% in 2017 and 3.7% next year. A recent meeting concluded with a statement that “The outlook is strengthening, with a notable pickup in investment, trade, and industrial production, together with rising confidence.”

The World Steel Association expects slow growth in demand for steel as the economy expand. They project global steel consumption growth of 1.3% in 2017 and 0.9% in 2018.

The positive outlook for steel has led to a rally in iron ore since 2015. Recently concerns that supply is growing rapidly led to a pullback in the price. An oversupplied iron ore market has been partially responsible for the fall in the metal’s price.

VALE is one of the world’s largest producers and exporters of iron ore and pellets. In the most recent quarter, the company generated roughly 71% of its revenues from iron ore business. This makes it a volatile stock since the stock depends on a growing economy.

Looking at the shorter term chart of VALE below, we see the stock could be set to resume its rally.

VALE has retraced 50% of the rally that pushed the price up by 50% from its June bottom. A rally of that size is rare, yet VALE could still be undervalued.

Analysts expect the report to show earnings per share (EPS) of about $1.20 this year and $0.90 next year. For companies in cyclical industries where earnings depend on the economic cycle, it can be best to consider average earnings power of the company.

In this case, the average EPS over the next two years are expected to be about $1.05. The stock is priced at about 10 times that amount. A price to earnings (P/E) ratio of 15, an average P/E ratio in the stock market, provides a price target of about $15 a share. VALE could be about 50% undervalued.

A Trading Strategy for the Stock

VALE has extraordinary volatility in the past few months. The chart tells us the next burst of volatility could be to the up side. This is based on the fact that the price just bounced off of the 50% retracement level shown in the short term chart above.

In addition to that bullish indicator, the price also formed a double bottom pattern on the chart as it completed its retracement. A confluence of multiple indicators is considered to be a stronger signal than any one indicator.

To benefit from potential gains in VALE, an investor could buy shares of the company. This requires a significant amount of capital in order to obtain a meaningful position in the stock. This strategy also exposes the investor to standard risks of owning a stock.

To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. This strategy could be better than buying a stock for smaller traders or for those wanting limited risks.

To further limit the risks of the trade, an investor could use a bull call spread. This options trading strategies consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call.

This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.

Source: The Options Industry Council

Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

For VALE, the October 20 options allow a trader to gain exposure to the stock for the very short term price move that is likely. In the short term, the stock is likely to move slightly higher based on the chart as long as the up trend remains intact.

An October 20 $10.50 call option can be bought for about $0.20 and the October 20 $11.50 call could be sold for about $0.02. This trade would cost about $18 to open since each contract covers 100 shares of stock.

The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.

In this trade, the maximum loss would be equal to the amount spend to open the trade, or $18.

The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.

For this trade in VALE the maximum gain is $0.82 ($11.50- $10.50 = $1.00; $1.00 – $0.18 = $0.82). This represents $82 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $82 to open this trade. The trade will be open less than a week.

That is a potential gain of more than 350% of the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.

In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in Trading Tips Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.