Heavy Options Activity in Vale (VALE) and a Brief Lesson in Risk Reversals

Sales of existing homes fell for the third straight week, but it wasn’t as bad as analysts expected. This news is pushing the SPDR S&P Homebuilders ETF (XHB) lower by .07 cents to 16.73. Out of the box this morning we saw traders buying risk reversals in VALE (NYSE: VALE) and heavy volume in the June 32 calls.

While the connection between the news in the housing market and VALE may seem somewhat distant, the Brazilian mining company is one of the world’s largest producers of iron ore, nickel, and other commodity metals and minerals used in the manufacture of new homes and mechanical systems used in new home construction.

With this type of activity happening in the market, I thought it would be a great time to bring a unique options trade called the risk reversal to light.

Note: New home sales and durable goods numbers will be released tomorrow.

VALE: $31.49 up $1.4500 or 4.83% volume: 23.99 million shares

May10 32.00 Calls: volume over 9509, versus open interest of 587
May10 26.00 Puts: volume over 2710, versus open interest of 699
*Jun10 32.00 Calls: volume over 10879, trading last: $1.83 bid: $1.83 ask: $1.85 OI: 13348

Remember there are a couple hours left in the trading day and the volume of these issues may continue to rise, but this is where we are seeing some heavy options activity today. Also remember that options can be bought or sold and volume does not indicate which.

This is one of my team’s observations this morning. If you have others you would like to add to this list, please feel free to add them in the comments.

Example Options Strategy in VALE: How to Trade a Risk Reversal

A long risk reversal is the purchase of a call and the sale of a put with different strikes, which is similar to being long stock in that you have risk to the down side (short put) with the stock going to zero, but theoretically unlimited upside (long call) with a rise in the stock.

Traders sometimes use this trade to reduce cost and lower breakeven points as opposed to buying stock out right. For example, if the trader paid 1.05 for this risk reversal, his upside breakeven is 33.05 (call strike + premium paid), to the downside, because he paid for the Risky (that’s a nickname for the trade) the breakeven is 27.05 (put strike + premium). If the trade were made for a credit, you would subtract the premium from the strikes to find breakevens.

At the end of the day this is a bullish trade. The trader would need the stock to move higher to profit in this trade, but the trader has lowered their downside breakeven from $31.50 (current price of the stock) down to $27.05. If the stock doesn’t get above 32 by May expiration, the trader could lose their entire investment.

Please remember, outlining how to execute this type of trade is not a recommendation, but rather a primer in understanding trading strategies beyond “buy,” “sell,” and “hold.” Let us know if you found this example helpful, or if you have other strategies you would like to share with others here.

Photo Credit: Nathan Rein

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1. OptionsHouse Tuesday Morning Roundup: Surprising News for the Housing Market Leads to a Bump in Consumer Confidence, and Heavy Options Activity in Delta Airlines (DAL) and Vale (VALE)
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