I normally do not buy options, but I have found ITM calls to be a cheap substitute for certain types of stocks. Commodity prices have been rising spectacularly so many mining stocks have been on a tear. As most of these stocks pay little to no dividends, there is not much incentive to own the stock if all we are hoping for is capital gains. Mining stocks are also very volatile – they can go up 20% in a few weeks but can also fall the same amount in a few days. Because of the high volatility, option premiums for these stocks tend to be very high. We could sell puts but it may not be worthwhile to collect 5% in premium if the stock falls 20% in value.
My favourite way for trading mining stocks which have options is buying deep in-the-money (ITM) calls. We can capture most of the potential upside while limiting our downside risk with this strategy. Let’s walk through an example using OZL to understand why this is my preferred strategy. OZL is one of the beaten down mining stocks which has been in a long term down trend after it peaked at $15 in 2011. It looks like the trend may be reversing – we can see a “golden cross” (the 50 day MA has crossed above the 200 MA) on the charts.
OZL has just broken out above a strong resistance level at $7 and was trading at $7.94 at the time of writing this post. If this breakout is real, the stock could run a lot higher. We would like to be able to participate in the upside while limiting our loss should our analysis be wrong. As OZL is an optionable stock, we can use options to help us to this. Below is the Feb-17 option chain for OZL.
We could buy the $8 at-the-money (ATM) call which will cost us $0.64 (ask price). As the stock price is trading at $7.94, there is no intrinsic value in this option. The 64 cents we pay is purely time value which will decay over time. OZL must be trading above $8.64 in Feb 2017 for us to make money. The delta for this option is 0.5347 which means the option will increase by only 53 cents if the stock goes up by one dollar.
Alternatively, we could buy the $6 in-the-money (ITM) call for $2.14. With the stock price at $7.94, There is $1.94 of intrinsic value and a time value of only 20 cents. The intrinsic value will not decay over time if the stock price stays the same. The delta for this option is 0.9016 which means the option will increase by 90 cents if the stock goes up by $1. If the stock price continues to rise, the $6 option will become deeper ITM and the delta will continue to increase and this option will behave more and more like the stock. The $6 option costs a lot less the stock so it ties up less of our capital as shown below:
Cost of 5 contracts of Feb-17 $6 options = $2.14 x 5 x 100 = $1070
Cost of 500 shares = $7.94 x 500 = $3970
When trading volatile mining stocks, it is probably a good idea to have a stop loss. Let’s say our stop loss is at $6 and the stock price falls to $5.94 after a month. If we had bought the stock at $7.94 and sold it at $5.94, our capital loss will be $2. If the stock price is at $5.94, our $6 option will still have some time value left if there is still 2 months to expiry. The best part with owning the option rather than the stock is if the stock gaps down to say $5, the most we can lose with the option is what we paid for it. If we size our position accordingly, we will not need to actively manage any losing trades. In the above example, if I am prepared to lose $1070 on this trade, then there is no need for me to do anything even if the price of OZL falls well below $6.
If all goes well and OZL is trading at $10 on or before February 2017. Our $6 call will be worth $4 or more. If we believe the stock can still go up, we can take some profit off the table by rolling our Feb-17 $6 call to another cheaper ITM call which is not as deep ITM with more duration such as an Apr-17 $8 call.