PCU = Low Risk?

02/04/09 09:14:42 AM

by Donald W. Pendergast, Jr.

Copper appears to be under heavy accumulation by the major commercial segment of the futures market. Here's a low-risk option play on one of the better long-term copper stocks.

Security: PCU
Position: Accumulate

It's been quite a ride south for the entire copper complex since the commencement of last summer's commodity rout. Southern Copper (PCU), one of North America's largest mining companies, is involved in the mining and production of copper, zinc, molybdenum, lead, gold, and silver. The Phoenix, AZ–based firm employs approximately 12,000 individuals, and it conducts its operations in Central and South America. Currently, PCU shares are going for about 30% of what they sold for at their 2007 peak. Given that the worldwide appetite for most commodities has slacked off since last year, is there any compelling reason to even consider an investment in such a beaten-down sector of the stock and commodities market? Perhaps there is, using options.

FIGURE 1: PCU, MONTHLY. A major cyclical low occurring near a major long-term uptrend line may hint at the possibility of a major move.

Graphic provided by: MetaStock.

Graphic provided by: WB BLine EOD from ProfitTrader for MetaStock.

PCU's monthly graph depicts the horrific plunge — month after month of brutal declines, with nary a moment of relief in sight. However, even the worst bear markets come to an end, and the action of the monthly WB B-line oscillator (bottom of Figure 1) is at its lowest level in at least 12 years. The B-line is a terrific measure of both cyclical and overbought/oversold tendencies in most stocks and commodities. At the same time, note the major long term uptrend line (blue dashed line); it hasn't had a monthly close of any significance below the line since its inception in mid-2003. The combination of the extremely oversold B-line and the essentially intact major uptrend line helps paint a bullish picture going forward.

FIGURE 2: PCU, DAILY. Selling a bull put spread requires a strong support barrier above the short put strike, bullish fundamentals, high options implied volatility, bullish price cycles, and strong money flow trends.

Graphic provided by: MetaStock.

Reviewing PCU's daily chart (Figure 2), we can learn even more about the specific shorter-term technicals; a strong area of support is found near $13.25 (red horizontal line), the stochRSI indicator is close to a cyclical low, and the accumulation/distribution indicator (a measure of volume action that is normally used to spot divergences and to confirm existing trends). On top of all this, the latest COT reports on the copper futures market reveal that the commercials, the deep-pocketed firms that actually buy copper to run their businesses, are still heavily biased toward the accumulation side of the equation.

When you put the monthly and daily technicals together and then mix in the ultra-bullish commercial COT trend, going long copper looks reasonably safe, especially for long-term investors. Given that PCU also pays a stock dividend of $1.36 per share (that's 7.90% annually) and you have to wonder, "Is there anything else I should know about going long PCU right about now?" Well, of course there is — you can sell a short-term option credit spread for a decent price right now, and I'm going to show you how to do it.

Option volatility has been extremely high in PCU for the past few months, so it's a good time to sell option premium, all else being equal. Here's an interesting way to play a bullish credit spread in PCU:

Sell 1 March $12.50 put
Buy 1 March $10.00 put
----------------------------
Net credit: approximately 0.52 – 0.55

You may need to work the bid-ask spread a little to get these credits; needless to say, the more you get, the more profit you can make on the spread. The idea here is for PCU shares to expire above $12.50 at March expiration. If that happens, the entire spread expires worthless and you walk away with your premiums, scot-free. With each passing day, time decay will eat away at the value of both the long and short puts, allowing you the luxury of earning money for doing nothing but waiting for expiration Friday. If implied volatility drops, the spread will also benefit, too.

Is there a risk here? Of course, and it's the difference between the two strikes, less the credit received. Put another way, it's $250 - $55, or about $195 maximum risk. So why would anyone risk $195 for the opportunity to make $55, anyway? Isn't that a poor risk-to reward ratio? No, and here's why. First, you have a major support barrier between the current price of the stock and the short put strike at $12.50. Next, the technicals and fundamentals are all in the major bullish camp. Finally, you have time decay working on your behalf in addition to all of these other favorable dynamics.

Managing this trade is easy. if the spread doubles in value, close it out for a loss, no big deal. If the stock trends strongly higher, do nothing but watch the spread wither away to nothing, thus saving yourself the cost of closing commissions. If the stock vacillates in a trading range, consider booking profits if the spread declines by half or more, say, from 0.55 down to 0.30, 0.25 or less.

It's also best to use a deep-discount, direct-access broker if you plan to put on a number of these spreads; a few brokers charge $1 or less per option contract, making such credit spreads worthwhile. Commissions can make or break these kinds of trades, so cut the best deal you can with your broker or find one who can offer a better deal.

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:	lineartradingsys@gmail.com
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