Commodities Rally Makes This Trade Great Again

| January 27, 2017 | 0 Comments

copperHaving already moved up quickly in 2017, commodities like copper and gold look like they will have a breakout year. Here’s the one stock you want to trade for unlimited upside by June.

We’re barely two weeks into 2017, and it’s already clear that commodities could play a bigger role in the financial markets than they have in the past. While we may not return to the peak action days of commodity trading circa 2011-2012, there certainly could be a resurgence in the sector.

Already this year, I’ve talked about gold and uranium and their potential for big gains. (Since I talked about buying gold at $1,150 per ounce the first week of the year, it’s since climbed to over $1,200 an ounce.) Shifts in the global economy and new policies from the incoming administration are both reasons why gold and other commodities could be in for a rally this year.

However, this time around, I want to focus on copper. The most widely tracked industrial metal could be set for a big 2017.

So, what’s the deal with copper?

First off, it’s important to understand the key factors influencing copper prices. On one hand, you have the strength of the US dollar. Commodities in general move opposite of the US dollar, so the strong dollar we’ve seen for the last several years has been a headwind on most commodity prices. (Since most commodities are globally priced in dollar terms, a stronger dollar means less commodities purchased, all else being equal.)

On the other hand, you have supply and demand factors. Copper is an industrial metal, so it’s used in things like wiring and construction. As such, the demand for copper goes up when more products and buildings are being built, aka a growing economy. In fact, copper is a common gauge of economic growth, especially in regards to industrial production.

Therein lies the dilemma…

You see, we are definitely experiencing global economic growth (although it’s more noticeable in the US than elsewhere). At the same time, we’re dealing with a very strong dollar. These two factors should essentially be offsetting each other in the copper market.

Or are they? Let’s look at the chart of spot copper prices for the last three years.

copper

The price of copper dropped substantially from 2014 to 2016 as the dollar reigned supreme. However, the price spiked at the time of the election. Trump’s surprise victory sparked hope that his $1 trillion infrastructure spending will come to fruition. Of course, infrastructure projects will require lots of copper. Here’s a clear case where potential for increasing demand is outweighing dollar strength.

So now what? The dollar is expected to remain strong with interest rate hikes resulting in even more dollar buyers. Trump’s infrastructure plan may or may not happen, and could take a while to get started even if it passes Congress.

Nevertheless, you can see where copper prices were just a few years ago. Given the strength of the economy, there are plenty of reasons to believe copper will be in higher demand once again. What’s more, as long as infrastructure spending is in the public discourse, copper prices will reflect an expected increase in demand at some point.

Not sold on copper by itself? How about we throw gold into the mix. I’ve already discussed how gold is a good hedge against political and economic uncertainty. You can see from the chart, it’s already becoming a popular safe-haven investment over the last several weeks.

gold

That’s where Freeport-McMoRan (NYSE: FCX) comes into play. The $22 billion natural resource giant relies on both gold and copper for revenues. By investing in this one company, you get two commodities for the price of one.

The stock is already on the move, as you can see from the chart below. However, the share price has plenty of upside, given where it was trading prior to 2015.

Freeport-McMoRan

Here’s the thing…

If you’re interested in FCX, why spend over $1,500 to buy 100 shares, when you can spend just over $200 to buy the $15 call expiring in June? For nearly six months of control, you’d spend just 13% of the cost of 100 shares of stock to buy one contract of FCX calls (1 contract = 100 shares). FCX has really cheap options because the stock price is so low. That’s why it’s such a great deal buying options instead of the stock itself.

In this case, the stock would only need to reach roughly $17.25 by June to break even. The upside is unlimited if FCX were to really start attracting investors.

Or, you could cut your cost by selling a higher strike call. Let’s say you think the FCX rally will be capped at $20 by June. In this case, you’d sell the June 20 call for around $0.50, while simultaneously buying the June 15 call for around $2.00. The result is only $150 in premium to control 100 shares of FCX until June. The only difference is that you’re capped at the $20 share price in terms of profits. (You’ve also reduced your breakeven price to $16.75.)

No matter what strategy you choose, it’s obvious to see the huge benefit you get by using options instead of buying stock outright. The cost benefit of using options is so extreme, there’s almost no reason to buy FCX stock if you plan on holding for a year or less.

 

Note: Jay’s colleague, Tim Plaehn, is the lead investment research analyst for income and dividend investing at Investors Alley. He is the editor for The Dividend Hunter and 30 Day Dividends.

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Category: Options Trading Strategy

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Jay Soloff is an options analyst with Investors Alley.