Buying Freeport-McMoran at a Better Price Than the Market Is Offering

Mar. 6.11 | About: Freeport-McMoRan Inc. (FCX)

Freeport-McMoran Copper & Gold, Inc. (NYSE:FCX) is a stock that we have had our eye on for some time. However, we want to buy high quality stocks at fair or even bargain prices. To us, “fair” means a price that combines the concept of value with an opportunity for above average price appreciation in the future, while accounting for the potential risk of loss.

Recently, there has been a flurry of favorable news about the company. According to the FCX website, last October the company increased the annual cash dividend on its common stock from $1.20 to $2.00 per share. In December, the company declared a special common stock dividend of $1.00 per share and also declared a two-for-one split of its common stock, effective February 1, 2011. Most recently, on February 24, 2011 the company issued a notice to redeem all of its approximately $1.1 billion in outstanding 8.25% notes originally due in 2015 on April 1, 2011. Retiring long term debt, increasing dividends, improving value for shareholders.......these developments are compelling.

As investors, a dilemma that we repeatedly face is identifying opportunities to acquire good securities after the good “news” becomes common knowledge. For most, that is almost always the case; and usually, it is a time when everyone wants to buy the stock. Ideally, we want to consistently buy stock at support and sell at resistance. It isn't any more complicated than that. However, it becomes more difficult and challenging when market risk is high, sectors are overbought, or when we can't exactly time the “top” or “bottom”.

Instead of buying and selling options as trading vehicles, we view them as tools to effectively create our own bargains and help us to control risk when we buy stock. By employing various option strategies effectively, timing doesn't have to be absolutely precise. With this in mind, we think that now is a good time to purchase FCX at a better price than the market is offering today, yet still control our exposure to risk.

Why FCX? Size, strength, safety and diversity. From the company's website:

We are the world’s largest publicly owned copper company, the world’s leading producer of molybdenum and a significant producer of gold. Our size gives us the advantage of greater profitability by means of volume and operating efficiency. Our financial strength also makes it more affordable to discover and develop new deposits and increase reserves – especially compared to companies with fewer properties.

Technically, the stock is beginning to make lower highs and lower lows; and this is consistent with recent market activity in high grade copper. This may be a correction or it may be a sign of what is coming in the broader economy, as copper is often considered a leading indicator of economic strength or weakness.

On a point and figure chart the stock has touched its trend line at 50.00 and held support. Fibonacci support on a candle chart is at 49.00, with trend line support at about 48.50. If this support band doesn't hold (and it may not), the next major support band is at 41.50 - 45.00. How can we purchase FCX at a price effectively lower than the present market price and also control the risk that it may decline significantly over the next ten months?

A number of traders familiar with options might try to “collar” the stock. That is, purchase near or at-the-money puts and sell overhead covered calls to help pay for protection from risk. That is one way to introduce risk control, but we sometimes prefer an option strangle in order to improve the reward profile of the trade as well.

Try this:

  • Buy FCX stock at 51.00 or better; and
  • Sell January 55 calls at 6.00 each to cover; and then
  • Sell 1 January 45 put at 5.00 for each 100 shares we purchase for a combined credit of 11.00

Here is how this may work out by January 20, 2012:

  • A. FCX closes above 55.00, the puts expire worthless and our stock is called away
  • B. FCX closes between 45.00 and 55.00, the options expire worthless;
  • C. FCX closes below 45.00, the calls expire worthless and more FCX stock is assigned to us.

Under Scenario A, we earn a profit of 15.00 on an investment of 96.00. If the company pays the projected annual dividend we receive an additional 2.00. Our annualized return is 21% assuming put sales are covered by cash; and we'd be starting from scratch looking for a new entry point.

In Scenario B, we keep the 11.00 option premium and continue to hold our original FCX stock, reducing our effective entry price to 40.00 per share and increasing the dividend yield to 5% going forward. If this scenario becomes a reality we will have to evaluate how best to protect, adjust or liquidate the position on or before January 20, 2012. We would very likely be looking to add to our position in this scenario.

In Scenario C, we also keep the 11.00 option premium, our number of shares in FCX is doubled and the average entry price per share is 42.50. In this scenario there is risk of loss in the trade. While there is support in the 41.50 – 45.00 price band as noted, a sobering fact is that not unlike many other stocks, FCX plunged 87% from June to December 2008. So we will need to be alert to make adjustments to the trade should a catastrophic situation present itself.

On the other hand, hypothetically if FCX is between 42.50 - 45.00 when the options expire, we could liquidate the entire position and still not lose money on the trade. Overall, this is a pretty effective balance between controlling risk and maximizing reward on a solid company whose price may go up or down near term.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in FXC over the next 72 hours.