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Several weeks ago, I posted an article about the value of investing in Cliffs Natural Resources (NYSE:CLF) at its current trading price. It was a good deal then, it's a better deal now. Some people showed hesitation about going long on the stock so I came up with a few options ideas as a way to control risk. Before getting into the options spreads, I want to outline the fundamentals (full analysis here)

  • CLF is trading at a Price/Book ratio of below 1 now (you're paying under $1 for every $1 of assets the company owns) while the industry average P/B is 6.20
  • CLF's last dividend yield was 5.50% compared to the industry average of 2.50%
  • CLF pays out only 14.6% of free cash flows as dividends while the industry pays out 48.9%
  • CLF brings in a revenue of over $900,000 while the industry average stands at $450,000

The fundamentals all look great so investors may be wondering why CLF is getting slaughtered by the market. The quarter over quarter revenue is down 10% for CLF while the earnings per share (EPS) are down 10% compared to this quarter last year. The industry is also showing signs of slowing down, though EPS are down only 5% over last year.

Some may ask why you wouldn't wait for price to bottom out before investing. The reason I advise against this is because the technicals are NOT clear for CLF and a bottom will be difficult to predict. What's more, CLF hasn't seen its price at this point since November of 2009. There's a chance that it may move lower before it reverses to an uptrend, though it may be in the best interest of long term investors to risk giving up some of their potential profits and get in now incase this is the bottom.

Options are a great way to invest in a company with a smaller initial investment. The return on investment using options can be much higher than the return on going long over the same period. Options become really useful when you couple multiple contracts together which allows you to control risk based on your appetite for it. For CLF, I've come up with two possible options spreads for bullish outcomes that can be altered to fit each investor's personal preferences.

For the first spread, I want to use two legs. The first leg will be a long call contract at a strike price of $40 and an expiry at January 2014. The second leg will be a short put contract at a strike price of $30 and an expiry of January 2014. This spread provides an 18% downside protection (you would break even if, in January 2014, CLF was trading at $29.35). On the other hand, CLF would need to trade above $39.45 before you made a profit above the initial premium you collect from the sale of the put option (the stock would need to appreciate 10% by January 2014 for you to collect more than $95 per spread). This strategy has unlimited upside potential and is limited to downside losses of $3,000 per spread.

If the price of the underlying stock moves above $40, you would be able to "call" 100 shares for $40 and immediately sell for a profit or hold onto it for a longer term investment. If the underlying stock moves below $30, you would be required to buy the stock at $30 and immediately sell it for a loss or hold onto it for a long term investment. In the first case, you would make an immediate profit. In the second case, you would have bought CLF stock for $30/share which is a great deal. Between $30 and $40, both the call and the put options would be worthless and you would walk away with a profit of $95/spread which you collected as a premium. Here's the breakdown:

Expiry

Strike

Put/Call

Quantity

Cost/Premium

Long/Short

January 2014

$40

Call

1

-$585

Long

January 2014

$30

Put

1

$680

Short

My second strategy involves a spread with three legs. The first leg will be a long call contract for a strike price of $40 with the January 2014 expiry. The second leg will also be long. However, this one will be a put option at a strike of $30 expiring on January 2014. Finally, the third leg will be a short put option at a strike price of $75 and an expiry of January 2014. The third leg can be adjusted to a higher strike price for a larger initial premium, though you will limit profits should the price go above your strike price by January of 2014. Here's the breakdown:

Expiry

Strike

Put/Call

Quantity

Cost/Premium

Long/Short

January 2014

$40

Call

1

-$585

Long

January 2014

$30

Put

1

-$685

Long

January 2014

$75

Put

1

$4010

Short

With this spread, your breakeven point is $44. Should the price in January of 2014 be below $44, you can suffer a maximum loss of $1,760. Should the price be above $44, you will have at least some profit. Upside potential is unlimited.

Both strategies are for a bull case for CLF. As an investor, it's in your best interest to play around with the number of contracts in each leg to customize the risk/reward ratio to your liking. Optionistics provides a handy calculator to visualize your profit/loss based on market value of CLF at expiry.

As always, it's important to remember that any type of investing has its risks and you should do your homework before jumping in. You should make sure you know your maximum losses in an investment and weigh if the reward is worth the risk. The first strategy I outlined provides a profit anywhere from $29.22 up but has the disadvantage of steep losses below that price. The second strategy requires price to move above $44.00 before you profit, however losses are capped at a maximum of $1,760.

Source: 2 Options Strategies For The Cliffs Natural Resources Bull