There are times when it makes sense to take bullish positions in breakout stocks ahead of long-term advances. And then there are periods when that strategy is dangerous because equities have already advanced to the point where breakouts are prone to failure.
In today's market, in which we have blue-chip indices routinely hitting new highs while small caps have faced more pressure, I am hesitant to buy breakouts. The bull market may still have legs, but many stocks' valuations are at premium levels, leaving them vulnerable to significant pullbacks.
Rather than using our put-selling strategy on one of the many stocks trading at new highs, I want us to set up an income trade using a stock that has been under pressure and may very well be finding support.
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Shares of Vale (NYSE: VALE) have closely tracked the spot price for iron ore over the past several quarters. As questions emerge regarding future infrastructure development in China, prices for iron ore have declined. This has been compounded by the fact that the big three iron ore producers, BHP Billiton (NYSE: BHP), Rio Tinto (NYSE: RIO) and Vale, have made significant investments in their infrastructure to increase production levels.
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As you can see in the chart below, iron ore is currently trading at the lowest levels seen in more than four years.
While the challenges for iron ore are certainly significant issues to consider, a nearly 50% decline in price over the past three and a half years may very well represent washed-out levels. At this point, it is reasonable to assume that the bad news for this commodity is pretty much "baked in" the current spot price, and iron ore producers are likely to rally or at least find support.
VALE is trading at a very attractive 6.8 times next year's expected earnings per share (EPS) of $1.95. With sentiment already fairly bearish, the likelihood of any negative news for iron ore sending the stock lower appears to be less than the likelihood that a piece of good news will send the stock higher. And with today's put selling strategy, even if the stock goes nowhere, we still benefit.
After hitting a low of $12.29 in March, VALE recently found support above that level. If these support areas hold, technical traders will likely have more confidence that the low is in, and we may see more capital start to move into the stock.
To set up our income trade, I want to sell the VALE Jul 13 Puts, which are currently trading near $0.36 per share. By selling these puts, we are accepting an obligation to buy 100 shares of VALE per contract at the $13 strike price should the stock be trading below this level when the puts expire on July 18.
Since we are collecting $0.36 per share in premium ($36 per contract), our net cost for the stock would be $12.64 per share ($1,264 per contract), well below the current market price. We will need to set aside this amount in case shares are assigned.
Assuming the stock remains above $13 and the puts expire worthless, our $36 profit represents a 2.8% return over the $1,264 in capital set aside. Since the puts are scheduled to expire in 38 days, our per-year rate of return nets out to roughly 27%.
Of course, if VALE were to trade below $13, we would be required to fulfill our obligation and buy shares. This has the potential to wind up being a very profitable trade. At this point, we are taking ownership at a 6.5 P/E ratio, giving us an excellent value for our investment dollars. Meanwhile, with relatively bearish sentiment for the stock, there is plenty of room for a shift in expectations and a significant rebound in the stock as valuations expand.
Based on this and the attractive level of income we can generate, the VALE Jul 13 puts represent an excellent income opportunity -- whether generating a 27% per-year rate of return over the next few weeks or a much larger return as the stock rebounds.