After a monster rally of 120% from the Feb. 26 low of $2.71 to over $6, shares of Vale SA (ADR) (VALE), the world’s largest producer of iron ore and pellets, have come under some serious pressure lately.
Click to Enlarge VALE stock has retraced about 30% of the recent gains, closing near the $5 level. I look for the stock to consolidate post earnings on April 27, and close near the major support at the $4.88 level.
As the largest producer of iron ore and pellets used in steel making, Vale is highly correlated to the price of iron and steel.
With steel prices having gone parabolic up until recently on further hopes of increased Chinese stimulus, VALE stock certainly felt the beneficial effect.
Goldman Sachs said in a early March note that the recent gains probably won’t last.
Click to Enlarge Now that steel prices, and VALE stock, have pulled back off the highs, I look for VALE to trade sideways over the upcoming week.
Earnings are due after the close on April 27, with expectations of $5.38 billion in revenue and 8 cents in per-share profits.
I am not expecting any major fireworks, but the option market certainly had priced in a fairly big move.
Click to Enlarge The term structure of volatility has steepened dramatically in front of earnings, with the at-the-money April options that expire this Friday trading over 40 vol points higher than similar options that expire May 20.
In plain English, this means that the shorter-term April options are very expensive compared to the longer-term May options.
The “Steel” Trade
So selling the expensive April options and buying the cheaper May options makes intuitive sense to me. Given my slightly bearish stance on VALE stock, a put calendar trade trade is a simple way to go.
Specifically, I would look to buy the VALE May $5 puts (expiring May 20) and sell the VALE April $5 puts (expire April 29) for a 12 cent net debit.
As mentioned earlier, the trade incorporates selling expensive April put options (124 implied volatility) and buying comparatively cheap May options (80 implied volatility), while positioning with a somewhat bearish view.
The maximum risk on the trade is $12 per spread. Ideally, VALE closes near the $5 level this Friday post earnings.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at tbiggam@deltaderivatives.com