Trading Commodities - Sell NEM Call Spreads, Buy PD Call Spreads
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Trading Commodities - Sell NEM Call Spreads, Buy PD Call Spreads

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Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge......

Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund managers and other active fund managers worldwide. Ryan Renicker, CFA

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  • 1. April 28, 2006 Sell NEM Call Spreads, Buy PD Call Spreads Ryan Renicker, CFA • In recent months, commodities – and stocks having exposure to them – have rallied across the 1.212.526.9425 board. This has often been accompanied by increasing implied and realized volatility in theseryan.renicker@lehman.com names. Devapriya Mallick 1.212.526.5429 dmallik@lehman.com • Lehman Metals & Mining analyst Peter Ward views NEM’s multiple as excessive and believes potentially higher gold prices have already been discounted in the company’s valuation. Ward maintains a 1-Overweight rating on PD, based on the belief that rising global copper supply will prove difficult. • 9-month implied volatility for NEM options is near a two-year high, while PD 9-month implied volatility has declined sharply, indicating that longer-term risk expectations are high for NEM, relatively low for PD. In addition, this infers NEM options are relatively “rich” and “PD” options are rather “cheap”. • We recommend expressing bearish views on NEM by selling the Jan ’07 60-80 call spreads, to fund a purchase of PD Jan ’07 87.5-90 call spreads, for a net credit of about $1.90.Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict ofinterest that could affect the objectivity of this report.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them,where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2LEHMAN to request a copy of this research.Investors should consider this report as only a single factor in making their investment decision.PLEASE SEE ANALYST(S) CERTIFICATION AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 4.
  • 2. Equity Derivatives Strategy | Sell NEM Call Spreads, Buy PD Call Spreads Commodities Rally, Risk Expectations Rise As Well In recent months, commodities and stocks with exposure to them have rallied steadily for a variety of reasons, some fundamentally driven (demand supply imbalances, liquidity, inflation concerns), others technical (investor speculation, creation of commodity ETFs). For example, during the past 8 months (8/30/05 – 4/27/05), gold spot prices have increased about 46.81%, while the Philadelphia Stock Exchange Gold and Silver Index (XAU) is up 62.74% (S&P 500 up 8.38% in same time period). Contrary to what is often seen for rallying stocks, XAU implied volatility has increased, closely tracking its realized volatility (Figure 1). A similar pattern was observed during the later part of the technology “bubble”, when a rise in the tech-heavy Nasdaq 100 Index (NDX) was accompanied by increasing implied and realized volatility (Figure 2).Figure 1: XAU Index Implied, Realized Volatility Figure 2: NDX Index, Volatility (8 Months Ending 3/31/2000) 160 40% 5,000 57% NDX Index 38% 4,750 150 NDX 3-Month Implied 52% 4,500 NDX 66-Day Realized 36% 140 4,250 47% 34% 4,000 XAU Index Level NDX Index Level 130 3,750 Volatility Volatility 32% 42% 120 3,500 30% 37% 3,250 110 28% 3,000 32% 100 26% 2,750 XAU Index 2,500 27% 90 XAU 3-Month Implied 24% 2,250 XAU 66-Day Realized 80 22% 2,000 22% 05 05 5 5 5 5 06 06 06 6 6 99 99 99 9 9 9 9 00 00 00 0 g- p- -0 -0 -0 -0 -0 r-0 -9 -9 -9 -9 -0 ct ov ov ec n- n- b- ar g- p- p- ct ov ov ec n- b- b- ar Au Se O N N D Ja Ja Fe M Ap Au Se Se O N N D Ja Fe Fe MSource: Lehman Brothers, OptionMetrics, Bloomberg Source: Lehman Brothers, OptionMetrics, Bloomberg Mining for Opportunities in Stocks with Commodity Exposure NEM (Newmont Mining Corp, $56.72) has continued to trade at a multiple of over 30 times 2006 earnings, which Lehman Metals & Mining analyst Peter Ward views as excessive, considering it has just a decade of reserves and that other commodity stocks trade at cheaper valuations1. Ward sees gold mining costs continuing to increase and potentially higher gold prices adequately discounted in NEM’s valuation. Among stocks with exposure to copper, Ward has maintained a 1-Overweight rating on PD (Phelps Dodge Corp, $81.86), based on the belief that increasing global copper supply will prove difficult with mature mines facing shortages of labor, machinery and tires. Demand is also expected to be higher, with China accounting for almost 23% of global demand. PD declined 4.36% yesterday (S&P 500 up 0.33%) after reporting first quarter earnings, driven partly by extraneous factors such as the People’s Bank of China’s decision to raise the benchmark working capital lending rate. Lehman’s Global Economics team believes that while further tightening measures could weigh on global commodity prices, Chinese policy makers do not aim to slow the economy sharply2. Investors with a longer term bullish view on PD could use yesterday’s weakness as an opportunity to get upside exposure in the stock. 1 Please see Newmont Mining: Given Strong Gold Price, Fair Results, Peter Ward, April 21, 2006 for further details. 2 Please see China: Unexpected interest rate hike is an encouraging sign, Global Economic, April 27, 2006. April 28, 2006 2
  • 3. Equity Derivatives Strategy | Sell NEM Call Spreads, Buy PD Call Spreads From a volatility perspective, medium term risk expectations for gold stocks in general and NEM in particular have continued to rise and are close to their two-year highs. However, PD 9-month implied volatility has collapsed more than 10 vol points over the last two months. In terms of absolute volatility levels, PD has been trading at a discount to NEM since the middle of April (Figure 4).Figure 3: NEM 9-Month Implied Vol Near Two-Year High… Figure 4: …While PD 9-Month Implied Vol Has Declined Sharply 45% 70 45% 100 NEM 9-Month Implied Vol 90 60 NEM Price 80 Implied Volatility (9-Month) Implied Volatilty (9-Month) 40% 40% 50 70 NEM Stock Price PD Stock Price 60 40 35% 35% 50 30 40 20 30 30% 30% PD 9-Month Implied Vol 20 10 PD Price 10 25% 0 25% 0 04 05 4 05 5 06 04 05 4 5 4 05 5 06 04 05 4 5 04 05 06 04 05 04 05 06 -0 -0 -0 -0 -0 -0 -0 -0 n- n- b- b- g- g- n- n- b- b- g- g- r- r- r- r- r- r- ec ec ec ec ct ct ct ct Ju Ju Ap Fe Ap Fe Ap Ju Ju Ap Fe Ap Fe Ap Au Au Au Au O O O O D D D DSource: Lehman Brothers, Factset Source: Lehman Brothers, Bloomberg So What Should Investors Do? Investors wishing to express a bearish view on NEM by selling call spreads could consider writing the Jan ‘07 60 calls for about $6.10 and purchasing the Jan ‘07 80 calls for about $1.70. This results in a premium of $4.40 and the trade finishes in the money so long as NEM finishes below $64.40 as of the January 19, 2007 expiration date. Part of this premium can be used to express a bullish view on PD’s relatively cheap options by purchasing call spreads maturing in Jan ‘07. The 87.5-95 call spread was offered at $2.50, as of last night’s close. Figure 5 shows the payoff of the combined strategy under different scenarios of NEM and PD prices as of the Jan ‘07 expiration.Figure 5: Expiration Payoff of Short NEM Call Spreads + Long PD Call Spreads StrategySource: Lehman Brothers, Bloomberg April 28, 2006 3
  • 4. Equity Derivatives Strategy | Sell NEM Call Spreads, Buy PD Call SpreadsAnalyst Certification:The respective research analysts responsible for the fundamental ratings hereby certify (1) that the views expressed in this research email accurately reflect ourpersonal views about any or all of the subject securities or issuers referred to in this email and (2) no part of our compensation was, is or will be directly or indirectlyrelated to the specific recommendations or views expressed in this email.I, Ryan Renicker, hereby certify (1) that the views expressed in this research email accurately reflect my personal views about any or all of the subject securities orissuers referred to in this email and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressedin this email.To the extent that any of the conclusions are based on a quantitative model, Lehman Brothers hereby certifies (1) that the views expressed in this research emailaccurately reflect the firms quantitative research model (2) no part of the firms compensation was, is or will be directly or indirectly related to the specificrecommendations or views expressed in this research report.Important DisclosuresLehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have aconflict of interest that could affect the objectivity of this email communication.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost tothem, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2-LEHMAN to request a copy ofthis research.Investors should consider this communication as only a single factor in making their investment decision.The analysts responsible for preparing this report have received compensation based upon various factors including the Firm’s total revenues, a portion of which isgenerated by investment banking activities.Stock price and ratings history charts along with other important disclosures are available on our disclosure website at www.lehman.com/disclosuresAnd may also be obtained by sending a written request to: LEHMAN BROTHERS CONTROL ROOM , 745 SEVENTH AVENUE, 19TH FLOOR NEW YORK, NY10019Mentioned StocksNewmont Mining (NEM - USD56.72) 3-Underweight / Positive JRisks Which May Impede the Achievement of the Price Target: We recommend that investors sell Newmont shares. Our target is well below the current stock price.The risks to our target are A) that investors continue to be willing to pay an extremely high multiple for earnings achievable at the current gold price and/or B) thegold price has a significant and sustainable rally.Phelps Dodge (PD - USD81.86) 1-Overweight / Positive JRisks Which May Impede the Achievement of the Price Target: Our long-term forecast for copper is $1.40 per pound. The risk to our target price is that our copperprice forecast does not materialize.Disclosure Legend:J: Lehman Brothers Inc. or an affiliate trade(s) regularly in the shares of the subject company.Options are not suitable for all investors and the risks of option trading should be weighed against the potential rewards.Supporting documents that form the basis of the recommendations are available on request. Please note that the trade ideas withinthis report in no way relate to the fundamental ratings applied to European stocks by Lehman Brothers Equity Research.Guide to Lehman Brothers Equity Research Rating SystemOur coverage analysts use a relative rating system in which they rate stocks as 1-Overweight, 2- Equal weight or 3-Underweight (see definitions below) relative to othercompanies covered by the analyst or a team of analysts that are deemed to be in the same industry sector (“the sector coverage universe”). To see a list of companies thatcomprise a particular sector coverage universe, please go to www.lehman.com/disclosures.In addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1-Positive, 2-Neutral or 3-Negative (see definitions below).A rating system using terms such as buy, hold and sell is not the equivalent of our rating system. Investors should carefully read the entire research report including thedefinitions of all ratings and not infer its contents from ratings alone.Stock Rating1-Overweight - The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.2-Equal weight - The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a 12-month investment horizon. April 28, 2006 4
  • 5. Equity Derivatives Strategy | Sell NEM Call Spreads, Buy PD Call Spreads3-Underweight - The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.RS-Rating Suspended - The rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstancesincluding when Lehman Brothers is acting in an advisory capacity on a merger or strategic transaction involving the company.Sector View1-Positive - sector coverage universe fundamentals are improving.2-Neutral - sector coverage universe fundamentals are steady, neither improving nor deteriorating.3-Negative - sector coverage universe fundamentals are deteriorating.Distribution of Ratings:Lehman Brothers Equity Research has 1834 companies under coverage.43% have been assigned a 1-Overweight rating which, for purposes of mandatory disclosures, is classified as a Buy rating, 32% of companies with this rating are investmentbanking clients of the Firm.40% have been assigned a 2-Equal weight rating which, for purposes of mandatory disclosures, is classified as a Hold rating, 5% of companies with this rating areinvestment banking clients of the Firm.17% have been assigned a 3-Underweight rating which, for purposes of mandatory disclosures, is classified as a Sell rating, 61% of companies with this rating areinvestment banking clients of the Firm.This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approved byLehman Brothers International (Europe), authorized and regulated by the Financial Services Authority, in connection with its distribution in the European EconomicArea. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australiaby Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. (“LBIS”). Where this material is distributed by LBIS, pleasenote that it is intended for general circulation only and the recommendations contained herein does not take into account the specific investment objectives, financialsituation or particular needs of any particular person. An investor should consult his Lehman Brothers’ representative regarding the suitability of the product and takeinto account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This materialis distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as anoffer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any mannerwithout the written permission of Lehman Brothers. With the exception of disclosures relating to Lehman Brothers, this research report is based on current publicinformation that Lehman Brothers considers reliable, but we make no representation that it is accurate or complete, and it should not be relied on as such. In the caseof any disclosure to the effect that Lehman Brothers Inc. or its affiliates beneficially own 1% or more of any class of common equity securities of the subject company,the computation of beneficial ownership of securities is based upon the methodology used to compute ownership under Section 13(d) of the United States SecuritiesExchange Act of 1934. In the case of any disclosure to the effect that Lehman Brothers Inc. and/or its affiliates hold a short position of at least 1% of the outstandingshare capital of a particular company, such disclosure relates solely to the ordinary share capital of the company. Accordingly, while such calculation representsLehman Brothers’ holdings net of any long position in the ordinary share capital of the company, such calculation excludes any rights or obligations that LehmanBrothers may otherwise have, or which may accrue in the future, with respect to such ordinary share capital. Similarly such calculation does not include any sharesheld or owned by Lehman Brothers where such shares are held under a wider agreement or arrangement (be it with a client or a counterparty) concerning the sharesof such company (e.g. prime broking and/or stock lending activity). Any such disclosure represents the position of Lehman Brothers as of the last business day of thecalendar month preceding the date of this report.This material is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of LehmanBrothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may notbe suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and theincome produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates,interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may beused to pay that income. © 2006 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in yourhome jurisdiction.Lehman Brothers policy for managing conflicts of interest in connection with investment research is available at www.lehman.com/researchconflictspolicy. Ratings,earnings per share forecasts and price targets contained in the Firms equity research reports covering U.S. companies are available atwww.lehman.com/disclosures.Complete disclosure information on companies covered by Lehman Brothers Equity Research is available at www.lehman.com/disclosures. April 28, 2006 5