Yesterday, we suggested that investors close the short-put spread trade on BHP as virtually all the money that one could make on that trade was captured by those who participated. We also felt that the natural resource trade might be peaking in the short term, and a pullback may be around the corner. Within a similar thesis, we discussed how a rally in minerals, coal, and base metals would raise the VALE stock price in November of 2021
Vale is a massive natural resource company based in Brazil. Brazil has enormous natural resources, and Vale is the dominant company in that industry. Brazil is also a gigantic food producer, and most people do not realize it, but they are a leader in Ethanol, which helps with their energy independence. Pure Ethanol is available as a transportation fuel.
The Vale trade took more time to develop than the BHP trade, but fortunately, we structured the trade idea to consider this possibility. In addition, we were looking for a big cyclical move, so we suggested investors buy a risk reversal. A risk reversal is a stock replacement strategy where one buys an out-of-the-money call and pays for it by selling an out-of-the-money put. When initiating the trade in our ideal structure, one collects a net premium, giving it a little scary and room for error.
Vale was trading at $12.24 when we suggested the idea, and it closed trading yesterday at $20.03, up 64% in a little over four months. Since we were confident there was little downside risk, we suggested using a strike price on the put leg that was close to at-the-money. This strike allowed traders to collect a hefty premium. The long out-of-the-money call provides an upside kicker should the share price take off.
This big move is what happened. Not the short put is nearly worthless, and the call is so far in the money that it will behave like the underlying stock. This would be good if we thought the share price was poised to rip even higher form here. But the chart gives us pause.
The share price looks like it is stalling out at the $20 level, and we think the best-case scenario is for the stock to trade sideways for the next month or two. We would not be surprised to see the stock price give up $3 to $4 a share before the stock price moves higher. If things get out of hand, the share price could fall another buck, or so. We do not expect a disaster scenario. We give it just a 1 or 2% chance of happening. However, the charts suggest that VALE stock could trade down to $13.80 and perhaps even less.
We think traders should close the risk reversal given this set of possibilities and our view of limited upside. If the stock pulls back to the $17.50 area, we would suggest buying a new one with a similar structure (Buy OTM Call, Sell ATM Put) with at least six months to expiration, so the structure has time to ride the next bullish wave we anticipate.
The macro picture in stocks is looking worse to us. We recognize that the financial media is giving the all-clear in reaction to the bounce in share prices this past week. Some have even argued the bull market is back. This investor psychology is the perfect emotional backdrop that keeps investors invested during a rug pull.
We think investors should use the recent rally to take profits on their longs and reduce risk. Risk reduction is achieved by temporarily selling positions and moving to cash, or hedging by buying puts, put spreads, or selling call and call spreads.
We stumbled upon a chart that gave us pause, and we would like to share it with you. The following chart shows the price action of the S&P500 High Beta index. SPHBI is an index of the highest risk large-cap stocks, which led the market higher in the post-Covid-19 lockdown stock market rally.
Notice this index went virtually straight up from the March 2020 low, rising from just under 6,000 and peaking at around 19.500. This move was an astonishing 240% rally in 2 years.
We think there is a good chance the index is tracing out a Head and Shoulders formation, which is a reversal pattern. It signals that all is not well with the hyper-growth, tech, go-go stocks. Our interpretation is that a selloff of as much as 40% could be in the cards for this group of stocks. Investors in Cathy Wood ETFs may be about to experience a terrifying event.
