When discussing commodities-based stocks, there is usually correlation between the underlying commodity and the company's share price. As most of you know, there has been a pretty large rally in commodities stocks over the last few months. Gold and copper are near all-time highs again. Freeport-McMoRan Copper & Gold FCX, the copper mining stock, has followed copper higher to hit an all-time high of its own. The stock is now trading around $115.
One commodity that has lagged in the rally is oil. Black gold is stuck below $90, while its high was around $147 in 2008. Again, much like the commodity, Exxon Mobil XOM stock is trading around $72, well below its late-2007 high of $95.05.
When judging whether or not you think there is an opportunity in trading something like this, one of the first things you probably want to research is the security's highs of a couple of years ago. There has been a lot of speculation that a big part of the last rally in oil prices was just a massive short squeeze. If that is the case, then the current prices probably make more sense.
On the other side, there is almost no denying the fact that if global economic activity really accelerates, we can quickly reach a point that people start talking about demand outstripping supply in oil, and “Peak Oil.” In the intervening couple of years, we had the gulf spill, which has made it harder for companies to get permits to drill offshore. In those scenarios, you could see oil prices accelerate relative to copper.
Because the price performances of in copper and oil have been somewhat uneven this year, investors might want to look at ways to trade the stocks. Potentially, if you think copper has topped out, but want commodity exposure, you could consider a trade like going long XOM and short FCX deltas. There is a lot of risk to a trade like this. I would think about doing it with defined loss spreads, rather than being naked short FCX deltas. I am not recommending this trade, per se, but I think going through the risks involved in trying such a strategy can be really interesting. Let's take a look.
First, there is a difference between owning the stocks and owning the commodities. You could theoretically be right about the direction of the commodities and still lose money on the trade with the corresponding stocks. One way you could get hurt, for example, would be if FCX was purchased by another company or by China's sovereign wealth fund. There have been rumors about this in the past.
If you had the trade on and someone paid $150 per share for FCX, it would be hard to make money on the trade unless there was a huge rally in XOM. Another way someone could get hurt would be around adverse legislation of the oil industry. If oil prices spiked, politicians with an eye on 2012 could bring back the idea of a “windfall” tax on the oil companies. Even if the price of oil jumped to a record high, the corresponding rally in the stocks would be muted if the companies were forced to disgorge their profits.
Second, there could be some shock to one of the underlying commodities that blows up your hypothesis. If there was a huge oil find somewhere, it could alleviate thoughts that the planet is running out of oil. This would likely depress prices relative to those of copper, and your trade would most likely not be profitable.
Okay, so if you are not deterred by the various risks, how would you set up the trade to take a stand, but limit your risk? First of all, you have to make sure that you do not trade too many contracts. If you do spreads, I would figure out what your loss would be if you lost the maximum on both spreads. Say the XOM and the FCX positions both went against you. Once you know that number, you should make sure it is not too big relative to your account value (in my opinion, think less than 10%). One way to do this would be to buy the XOM Jan 2012 72.5/85 call spread for about $4.10 (buying the 72.5 strike, selling the 80 strike). Against it, you could sell the FCX Jan 2012 115/135 call spread for a credit of about $7.80 (selling the 115 call, buying the 135 call). Because of the differences in stock price and premium, you could buy 1.5 times as many XOM spreads as FCX. For argument's sake, let's say we bought 15 XOM spreads and sold 10 FCX spreads.
What would happen? If both spreads both finished out-of-the-money, the trade would be slightly profitable. Premium paid for XOM position would be $4.10*15*100, which would equal $6,150. Premium collected on the FCX spread would be $7.80*10*100, or $7,800. If they both finished out of the money, you would make $1,650 less commissions.
If both spreads finished 100% in-the-money, the trade would also be profitable, albeit slightly. You would make ($12.50-4.10)*15*100, or $12,600 on the XOM. You would lose (20-7.80)*10*100 or $12,200. The profit would be $400 less commissions.
Worst case would occur if the XOM spread finished out-of-the-money and the FCX finished in-the-money. At that point you would lose the $6,150 premium paid on XOM and you would lose the $12,200 max risk on the FCX spread. That is a total loss of $18,350. If we used my rule of worst case being 10% or less of your account value, then doing this trade 10 by 15 times would mean you needed an account of over $183,000. Even to do this trade 3/2, you would have to have an account worth $36,600. If you have less money than this, you probably are risking way too much money compared to how much you have.
Again, I am not advocating people to get long oil vs. copper, but I think that understanding risks on a pair trade like this is pretty important. These stocks provide an interesting example of how that can be constructed.
Photo Credit: maureen lunn
The above information is provided by OptionsHouse, LLC (“OptionsHouse”) for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.
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