Using Options To Trade Metals And Mining

| August 30, 2017 | 0 Comments

miningOne of the great benefits to options trading is the flexibility it gives traders to execute a strategy as they see fit.  With options, even traders who share an opinion on a trade thesis can go about the execution in vastly different manners.  This flexibility allows savvy traders to fine tune their trading strategy as much (or as little) as desired.

For instance, last week I wrote about a big trader going bullish on aluminum.  This trader bought Alcoa (NYSE: AA) calls in order to execute the strategy.  Her or she could have used an aluminum ETF or a base metals ETF, but instead chose the largest aluminum producer as the underlying asset.  In this case, the strategy was very straightforward call buying.

AlcoaOf course, we don’t know why the trader was bullish on aluminum and Alcoa.  It could be stock specific, commodity specific, or maybe he/she is bullish on the economy itself.  Keep in mind, industrial metals like aluminum often see higher demand prior (and during) economic growth.

As you can see, there are often multiple possibilities behind a strategy, and even more so if you take into account how the options can be executed.  The trader could have used a spread of some sort, or sold puts, written covered calls, or done something else entirely.

As a matter of fact, a similar big trade just occurred in the SPDR S&P Mining & Metals ETF (NYSE: XME).  First off, XME is an ETF which provides exposure to S&P 500 companies in the following industries: aluminum, coal, copper, gold, silver, steel, other precious metals, and other industrial metals.  Basically, most mined materials companies are covered by this ETF.

SPDR S&P Mining & Metals ETFWhat I like about XME is it essentially has dual strategic exposure.  You can use it go long precious metals, which are typically safe-haven investments.  Or, you can use it to go long industrial metals, generally more related to economic growth.

In other words, XME can get you some exposure to two very different types of market environments.  Because of the dual exposure, you wouldn’t expect this ETF to have too many wild swings.  And, this plays out in reality if you look at the chart.

Early in the summer, we had a period where there were reasons to be bullish on both precious and industrial metals.  You can see where XME reacted quite positively during the period, as would be expected.

One big trader believes this bullish market in industrial and precious metals is going to continue through the end of the year.  But, given the nature of the ETF, he/she also believes the upside is capped.  Of course, using options is ideal for this scenario.

More specifically, the trader purchased the December 32-35 call spread in XME, 10,000 by 15,000 times, for a total of $0.69 or $690,000 in premium.  XME was trading at $31.35 at the time of the trade, and the ETF only has to get to $32.69 for break even.

This type of call vertical spread is referred to as a ratio spread, since more calls were sold than bought.  The goal is reduce the premium paid and make the trade more affordable.  On the other hand, the additional short calls means there is unlimited loss potential on the upside (for 5,000 contracts).  If the ETF closes below $32 in December, the risk is only the premium paid.

The ratio spread buyer is well aware of XME’s trading patterns.  As such, the trader isn’t too concern about the unlimited upside risk (above $35).  By the way, $35 is the max gain point for this trade in December, with profits equal to $2.3 million.

I don’t recommend ratio trades like this for most options traders due to the unlimited upside risk.  However, if you like this trade (and I do), then doing it straight up isn’t a bad idea.  That is, just doing the 32-35 call spread 1×1.  It will cost you $0.96, but the premium paid is your entire risk.  Plus, you have almost 4 months of exposure and can still generate $2 in profit per spread if XME climbs to $35.

 

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Category: Options Trading Strategy

About the Author (Author Profile)

Jay Soloff is an options analyst with Investors Alley.

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