Bullish on Iron Ore? Use Options on BHP, Rio
Published: Sunday, 20 Feb 2011 | 7:19 PM ET Text Size By: Lianting Tu Assistant Producer , CNBC
Rising demand from China has been pushing iron ore prices to record highs lately. The Steel Index daily price for mid-range iron ore (grades with iron content of 62%) reached $189 per metric ton last week, the highest level since publication of rates began in November 2008.
The rising demand and supply shortage won’t go away anytime soon, according to Citi Investment Research. The firm says the iron ore market will remain tight until around 2014. For investors seeking to profit from this trend, a natural option is to buy stocks of iron ore miners such as BHP and Rio Tinto. Latest earnings of both companies surged with Rio Tinto tripling its full-year profit and BHP almost doubling first-half profit. Their stocks have also outperformed the benchmark S&P/ASX 200 index over the past year by a large margin.
But for investors looking to make a leveraged bet on this market, without having to put a lot of money up-front, equity options offer an alternative. The most straightforward approach is to buy a Call option on the miners. But Chen Wai-Yee Head Of Derivatives, Sydney Asian Desk at RBS Morgans recommends selling a put instead as a safer strategy. She recommends selling a May A$46.5 put on BHP, which generates A$1.75 in income. Selling a put gives the investor the right to buy the stock at the strike price in return for some premium income.
Bullish But Cautious
Chen says the advantage of selling a put on BHP rather than buying a call, is that you stand to make money whether the stock rises or goes nowhere.
“I’m long-term bullish on the both companies but cautious on the near-term because [there’s unlikely] to be a bullish catalyst,” says Chen.
Investors had been waiting for both companies to announce big share buybacks, and with that out of the way, Chen feels the shares of both firms are likely to trade sideways for some time.
If the shares of BHP were to rise or stay unchanged, the option would expire, and the investor would earn A$1.75.
Chen also recommends a similar strategy for Rio Tinto, selling a May A$86 put, which pays a A$2.82 premium.
The risks for investors in both strategies however, is that there is no downside protection. If shares of BHP were to fall below A$44.75 (the strike price minus the premium income) investors would stand to lose money. Similarly, in the case of Rio Tinto, investors would stand to lose money if the shares fall below A$83.18.