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Copper Fundamentals, Technicals, And An Option Play

01/28/09 07:24:33 AM
by Donald W. Pendergast, Jr.

The copper market was hit especially hard during the massive commodity slide of 2008, but now that the dust has settled, some signs of life remain.

Security:   HG#F
Position:   Accumulate

From its spring 2008 high of 427.00 to its recent low at 124.70, copper has covered a lot of ground -- straight down. Sagging construction demand in the US and rapidly cooling economies in the BRIC (Brazil, Russia, India, China) nations, combined with forced futures contracts liquidations during the worst phase of the credit crisis, all played major roles in cutting copper prices by more than two-thirds. Is there any redeeming value in acquiring copper now? Perhaps. There may be a fairly low-risk way to play this volatile market with options. See Figure 1.

FIGURE 1: COPPER, MONTHLY. High option implied volatility, potentially bullish COT trends, and oversold monthly technicals all combine to suggest that selling out-of-the-money puts in copper may be a low-risk way to generate cash.
Graphic provided by: MetaStock.
Graphic provided by: WBDetrendRTEOD from ProfitTrader for MetaStock.
The monthly copper chart (continuous contract basis) shows just how bad the decline has been over the past nine months. At first glance, it looks like a market to steer clear of, but a closer look is warranted. Technically, this market is very oversold, judging from the all-time low reading on the detrend oscillator and the extremely low reading on the stochRSI. The most recent candle is interesting; even though there are a few more trading days in January, the range is remarkably small this month, a sign that sellers may be more reluctant to short this market at such a low level. If a rally can materialize from such low levels, it will have a ton of overhead supply to work through. The Fibonacci 23.6% retracement is the most likely significant resistance point standing in the way of price recovery.

On the fundamental side, though, is where this market becomes downright fascinating. Since mid-September 2008, the commercial interests in the futures markets have maintained a very bullish posture, continuing to accumulate long contracts as the selloff gathered steam. If you've ever looked at COT charts, you quickly learn that commercials tend to do their major buying while price is falling before selling their positions back into the market as prices begin to rise again. Such a heavy long-side bias in copper for the past five months by such well-informed market participants (these are generally firms that actually produce copper and/or require copper to run their businesses) may just be an early indication that the smart money expects a rebound in copper prices during 2009.

So, copper might be preparing for a recovery of some kind. What now? Well, how about taking an approach to this market that doesn't require pinpoint timing accuracy, an approach where your price forecast could be off a bit and you could still make some money? If that sounds like an approach you'd like to investigate, here are the specifics:

Right now, implied volatility in copper options is relatively high, meaning that you can get a nice premium for selling put options. Given the oversold technicals and bullish COT fundamentals, selling a June 2009 1.12 copper put for about .0285 would put an extra $712.50 cash into your margin account. Expiration on June copper options is May 26, 2009, or about four months from now. The goal is for June copper (currently trading near 1.60) to close at or above 1.12 at expiration, causing the put to expire worthless, allowing the put seller to retain all of the $713 in premiums.

With every passing day, time decay will eat away at the option's value, and, hopefully, the implied volatility will revert to more normal levels, which will also shrink the value of the short put. Even better, if June copper stages a rally, say, up to the 23.6% Fib retracement near 2.00, the option's value will also decline as the option delta goes farther out of the money. All in all, it's a very compelling, relatively low-risk way to play the copper market.

But what if this market doesn't rally? What if copper suddenly starts to decline next week and the short put begins to increase in value? What then? The answer is simple -- buy back the short put if it doubles in value at any time before expiration. The biggest risk to this trade is if there is a massive selloff in copper within a few weeks of putting on the trade. If price declines very slowly, however, there is far less risk to the position and the fact that option volatility may also decline makes that scenario even less risky.

As always, traders need to see if such an option trade is appropriate for their skill level and account size.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title: Writer, market consultant
Company: Linear Trading Systems LLC
Jacksonville, FL 32217
Phone # for sales: 904-239-9564
E-mail address:

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Date: 01/28/09Rank: 4Comment: 

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