Options Update: Vale Sees Credit Spread Activity

Shares of iron-ore mining specialist Companhia Vale do Rio Doce
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have rebounded more than 3.5% so far today, as traders recover from yesterday’s nearly 12% drubbing. Prompting Monday’s sell-off was a downgrade to “hold” from “buy” at Canaccord Adams. The brokerage firm cited fourth-quarter earnings that were below expectations for the downgrade.

For reference, RIO said last week that earnings plunged 47% to $1.4 billion, or 26 cents per share, from $2.6 billion, or 53 cents, last year. Sales decreased about 12% to $7.4 billion from $8.4 billion a year ago. In a statement, Vale attributed the fourth-quarter results to the “widespread slump in industrial production,” which has led to “unprecedented weak demand conditions.”

In today’s trading, RIO has been targeted by some heavy put activity, seemingly related to the recent earnings report and analyst downgrade. In fact, put volume has outnumbered the stock’s daily average by nearly 7 to 1, placing the security on our Intraday Volume Explosion List. Approximately 82,000 puts have changed hands on the security, but it was the sizable block trades on the March 12 and March 10 puts that caught my attention this afternoon.

The Anatomy of a Vale Credit Spread

Digging into the activity, I discovered that 2 large blocks totaling 37,500 contracts traded on both the March 12 put (RXO OE) and the March 10 put (RXO OB) at about 10:06 a.m. Eastern time. The RXO OE contracts changed hands at the bid price of $1.12, while the RXO OB contracts traded at the ask price of $0.44. With the blocks trading at the same time on the same exchange, I can reasonably assume that these trades are related. In fact, it would appear that we are looking at a neutral-to-bullish credit spread on RIO.

Companhia Vale Do Rio Doce put volume details

A bullish credit spread involves selling a higher-strike put and purchasing a lower-strike put. This results in a net credit to the investor’s account. The maximum profit is achieved as long as the sold put stays out of the money by expiration. In today’s example, the trader needs RIO to stay above the 12 level by the close of trading on March 20, when these options expire.

So, how does today’s example work on paper? First, the trader purchases the RXO OB puts for a debit of $1,650,000 — ($0.45 * 100)*37,500 = $1,650,000. Next, the trader sells the RXO OE puts for a credit of $4,200,000 — ($1.12 * 100)*37,500 = $4,200,000. A total credit of $2,550,000 for the position is arrived at by adding the credit received from selling the March 12 puts and the debit incurred for purchasing the March 10 puts — $4,200,000 – $1,650,000 = $2,550,000.

Hedging Your Bets

So, why not just sell the March 12 puts outright and collect the entire premium? Well, the purchased March 10 puts act as a form of insurance against an unexpected plunge in the position. Once RIO breaches the 12 level, the sold 12 put becomes a liability, and continues to lose money until the shares breach the purchased 10 put.

By entering this trade, the investor is indicating that he expects RIO to hold above the 12 level for the next several weeks. The shares are putting on a show of buying strength in today’s trading, which could be a bullish sign in light of yesterday’s downgrade. That said, let’s see if the stock’s technical and sentiment backdrops provide any additional drivers for this trade.

Getting Technical

From a technical perspective, RIO has lost more than 66% during the past 52 weeks. But the shares have turned things around recently, besting the S&P 500 Index (SPX) by 21% on a relative strength basis during the past 60 trading days. The equity has rebounded nicely from its November lows near $9 per share, but a recent rejection near $18 per share has RIO reeling from a glut of selling pressure. Still, today’s rebound from the 12 level indicates that there are still plenty of RIO buyers in the market. What’s more, $12 per share is emerging as a key price point for these buyers, as the stock has closed only 1 session below this area since the beginning of the year.

Daily chart of Companhia Vale Do Rio Doce since November 2008

The Sentiment Drivers

Investor opinion toward RIO is weighted to the bearish end of the spectrum – a development that could provide support for the shares. Specifically, the stock’s Schaeffer’s put/call open interest ratio (SOIR) of 1.09 ranks above 83% of all those taken during the past year – hinting at pessimism from the options crowd. Meanwhile, short interest jumped by more than 11% during the most recent reporting period. If the shares can hold their ground above $12 per share, we could see some of these bears shaken out of their positions.

There is one caveat to this positive outlook for today’s trading example: analyst rankings. According to Zacks, RIO has garnered 4 “buys,” 5 “holds,” and no “sell” ratings. This configuration leaves the door open for potential downgrades that could push the shares below support at the 12 level, thus forcing a March 10-12 put credit spread trader into closing his position prematurely.

Sentiment indicators for Companhia Vale Do Rio Doce

The Verdict?

The recent weakness in the steel sector has me concerned that we may not have a bottom for RIO just yet. Still, there is the potential that the shares could benefit from short-covering or profit-taking by bearish investors following yesterday’s plunge. Sure, the shares don’t appear to be poised for a stellar rally that would thrill bullish investors, but conditions appear rather amiable for credit-spread traders.

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Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.