Cliffs Natural Resources: A Risk Reversal

| About: Cliffs Natural (CLF)

Cliffs Natural Resources (NYSE:CLF) is a large mining and natural resource company offering many characteristics of a good stock for an options trade. It is an extremely volatile stock, with a beta of 2.45. And it trades nearer the bottom of its large 52-week range of 32.25 to 78.85. The stock offers value and exposure to the metals/mining sector -- I believe that the negatives are priced into this name already, and in the coming six to 12 months prices will confirm stabilization followed by early uptrends in its core markets. When that occurs, the opportunities for initiating a position in CLF will have passed.

Given its agonizing six-plus month drop, CLF should act like a coiled spring in reaction to any good news. A recent September bounce from $33 to $45 confirmed this thesis, with CLF surging 35% in a less than a month. CLF is currently pulling back again, and we must be prepared to take advantage of the next price surge.

Options prices are as of 9/25/2012 market close, and CLF trades currently at $38.99.

Thesis: I am willing to get long CLF now at near $40 per share, with a 12-plus month time horizon. I look to structure an options trade that improves on this risk profile.

Trade (Assuming 10 contracts / 1000 shares):

  • Sell January 2014 $40 Puts for $11.20 (Credit of $11,200)
  • Buy January 2014 $35 Calls for $9.75 (Debit of $9750)
  • Overall net cash credit on the trade is $1450
  • Option: Sell January 2014 $75 Calls to establish a $30 call spread. Currently priced at $1.10. I would wait, and see if you could get $2 for these on a bounce (Credit of $1100 to $2000). I will not take this into account for the analysis.

Analysis (Assuming 10 contracts / 1000 shares):

  • CLF < $35 in Jan 2014: Our calls are worthless. We take possession of 1000 shares of CLF at an effective price of $38.55 (40k less our initial $1450 credit). Note that this is less than today's share price ($38.96), but we would have missed the intervening dividend ($2500 on 1000 shares). If you had sold the upside call for $1100 to $2000, and given the $410 improved basis, you can even out this dividend discrepancy.
  • CLF between $35 and $40 in Jan 2014: Our calls are worth 0 to $5000. Our puts are exercised. Break even is $38.55. Range of losses to gains in this window is a loss of $3550 at a price of $35, and a gain of $1450 at a price of $40. Note that the option call sale would drop the breakeven price of the trade up to $36.55 (assuming a sale of $2/contract), which helps a lot in this price window.
  • CLF above $40 in Jan 2014: Obviously, this is the sweet spot. We are executing the trade because we think CLF has a chance of recovering some of its losses in 2013, perhaps returning to the $60s. At CLF $50, the calls are worth $15,000. At CLF $60, the calls are worth $25,000.

Keep in mind that the "cost" of this trade is actually a cash credit to your account ($1450). And, of course, the margin and/or cash your broker will "hold" to cover the trade. My brokerage shows a holding of 20k in margin; that is, 20k is deducted from my available margin balance -- I need not pay interest unless I actually buy the stock with margin.

Whether you find this trade appealing depends in large part on your brokerage account, and how you structure your portfolio. I hold about 50% of my trading account in long-term stocks and index funds and perhaps 20% in cash. So when I execute the above trade, that is how my cash and steadier index and utility stocks are "working" for me. Over the long term, if you wish to sell such puts, establishing a basket of stable stocks is very helpful (not to mention prudent portfolio theory).

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CLF over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I was recently long CLF and short covered calls; the position was called away Sept 21. I am actively looking to re-enter CLF on weakness.