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Perspective on Trading Options on Natural Resource Companies

Patrick Ceresna
February 27, 2018
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Perspective on Trading Options on Natural Resource Companies

After our interview with Rick Rule on MacroVoices, I was inspired to share my thoughts on options trading on natural resource companies. At the start of the interview Rick pointed out the unusually cyclical nature of resource investing.  Rick went on to elaborate:

“…during periods of time when mature natural resource companies appear cheap (that is their enterprise value relative to their EBIT is low), they normally correspond with periods of very high commodity prices. Meaning that the price of the commodity is about to go down, so that the free cash flow is about to go down, so that the debt is about to go up.

When, by contrast, mature natural resource companies seem expensive on an EBIT to enterprise value basis, it’s normally when commodity prices are low. Meaning that cash flow is going to get higher and debt is going to get lower.

In truth, in the 40 years that I have been involved in the game, one looks first for commodities where you believe that ongoing demand for five or ten years is assured, because of the utility afforded by that commodity to society. That is where ongoing demand is assured. Where the price of the commodity – the price that the commodity sells for worldwide – is below the median cost of production.

In other words, you buy the best producers in industries that are literally in liquidation. What that means is that you have a circumstance where, either the price of the commodity goes up, or society does without the commodity. In terms of the broadly traded commodities, the truth is that our way of life depends on commodities. And I would suggest that that’s what sets apart the resource business from other businesses.”

I could not agree more with Rick, but this is where I feel I wanted to put context on options on mature resource companies.

At first glance, it appears options on resource companies are expensive, often with implied volatilities north of 30%.  But as Rick inferred when identifying the unusual cyclicality of resource stocks, I ask – does the implied volatility (the variance of expected returns) accurately reflect the cyclicality.

As an example, let’s take one of Canada’s largest resource companies, Teck Resources, which is currently pricing a 30%+ implied vol.  Now let’s retrace the history of the companies cycles over the last two decades.

Source: TradingView.com

 

May 2003 – $10.10 low
December 2006 – $95.16 high
November 2008 – $3.35 low
January 2011 – $64.62 high
January 2016 – $3.65 low
Present (February 2018) – $37.40

I ask – does the implied volatility accurately reflect the extreme cycles that resource companies go through?  History shows that Teck Resources makes extraordinary moves that any given year could see the company bearishly lose half its value or bullishly double in price.

Observe the 200 day realized volatility (in blue) vs the implied volatility (white) on TECK.B.  (February 26, 2018)

Source: Interactive Brokers

 

It is my opinion that not only are the long dated options on many resource companies “right priced”, but if you were to see the emergence of one of the big cycles these resource companies go through, options offer a compelling opportunity to build asymmetric risk reward propositions.

To demonstrate the asymmetry, one does not need to make this complex.  To demonstrate let’s compare a trader buying 100 shares of TECK.B vs. buying the January 2019 $37.60 call option for $4.50.

Let’s assume 3 scenarios  for Teck Resources over the next 6 months (August 31st).

Scenario 1:  Similar to the Sep2017-Jan2018 rally, Teck Resources bullishly rallies $15.00 higher to $52.00.  Under that scenario, the share investor is up $15.00 or 40%+.  The call option, net of its intrinsic value will have a value north of $15.00, making the call buyer profitable by $10.00+ and up several hundred percent on the risk outlay.  While one can look at the call option as a trade in itself, I remind you that if the call buyer remains very bullish, they could exercise the call option and take the stock ownership at the strike $37.60 price.

Scenario 2: Teck Resources ends up chopping sideways and remains unchanged in its price at $37.60.  The investor with the shares is flat.  The call buyer alternatively experiences time decay eroding the option to about $2.00 (assumption based on simulation) which is a $2.50 loss.

Scenario 3: Teck Resources ends up declining back to $25.00 (The level it traded back in the summer of 2017).  Under that scenario, the share investor is down $12.00 and needs a material rally to get back to break even.  Alternatively, the call option erodes to a $0.50 value experiencing a loss of $4.00, almost the entire value of the call.  But there is one key difference, the share owner is stuck in a losing position often resorting to dollar cost averaging to reduce their cost base.  Alternatively, while the call buyer did lose, they are free to walk away from the option and can buy a new call option at the $25.00 price to reset the trade.

Conclusion: 

While the cost and decay of the time value is often a deterrent, I would argue the call buyer had more risk control and flexibility than the share investor, which in the very volatile resource sector is arguably an important strategic advantage.

 

Patrick Ceresna
Patrick Ceresna http://www.bigpicturetrading.com

Derivatives Market Specialist

Big Picture Trading Inc.

Patrick Ceresna is the founder and Chief Derivative Market Strategist at Big Picture Trading. Patrick is a Chartered Market Technician, Derivative Market Specialist and Canadian Investment Manager by designation. In addition to his roll at Big Picture Trading, Patrick is an instructor on derivatives for the TMX Montreal Exchange, educating investors and investment professionals across Canada about the many valuable uses of options in their investment portfolios. Patrick is also co-host to the MacroVoices weekly podcasts. Patrick specializes in analyzing the global macro market conditions and translating them into actionable investment and trading opportunities. With his specialization in technical analysis, he bridges important macro themes with the attempt to understand when those trends are beginning and understanding where they likely to go. With his expertise in options trading, he seeks to create opportunities that leverage returns, while managing/defining risk and or generating consistent enhanced income. Patrick has designed and teaches Big Picture Trading's Technical, Options and Macro Masters Programs while providing the content for the members in regards to daily live market analytic webinars, alert services and model portfolios.

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