- Posted by Richard Croft on April 27, 2010 filed in Trading Strategies
Recently, a lot of academic literature has focused on momentum trading. Not a new concept, as it follows the “don’t fight the tape” analogy. But recent studies have attempted to put some time lines on the concept.
For example, stocks moving higher over the previous six months tend to continue rising for at least another three to four months. As the trend gets long in the tooth, macro-economic fundamentals tend to take on a more critical role. In other words, you have to find support in the underlying demand metrics to justify further upside momentum.
Not surprisingly, many Canadian stocks have benefited from momentum. Certainly over the past year. Predicated on strength in the global economy which has pushed up demand for goods like crude oil, iron ore, lumber, pulp, and rubber.
Teck Resources Limited (TSX, symbol TCK.B, recent price $42.30) and Canfor Corp. (TSX:CFP, recent price $10.90) are classic examples.
Teck is a major provider of metallurgical coal, copper and zinc. Metallurgical coal being particularly relevant, because it burns at higher temperatures making it an ideal fuel for steel producers.
Canfor is a forest products company, primarily involved in the lumber business with production facilities in British Columbia, Alberta, Quebec and the United States. It has surged more than 100% over the past 12 months on the back of increasing demand for lumber products from China and the United States.
Macro-economic fundamentals come into play because future demand - and the positive impact that will have on stock prices - is premised on continued above trend line growth in emerging Asian economies. Will emerging markets continue to expand at the same pace? Or, as some have suggested, have they moved up too far too fast?
Aside from the risks associated with future demand is the cost element tied to a rising loonie. Which is why late stage momentum trading is like a game of musical chairs. The trick is to know when the music stops.
For aggressive option traders, this could be an opportune time to establish bearish positions that leverage any near-term correction in these stocks. Or for conservative investors that have caught this rally, to consider protective puts or covered calls, as a partial hedge against a correction.
With TCK options trading at higher than average implied volatilities (note: implieds are in the top quartile of all sectors on the TSX), more conservative traders might establish partial hedges by writing the TCK May 43 calls (implied volatility 35.28%) at $1.20. More aggressive traders could still look at buying the TCK June 42 puts at $2.20 (implied volatility 36.55%).
The rationale for the option buying strategy centers on the position that implieds for TCK options are close to the average historical volatility (historical volatility 32.98%) being displayed by the underlying stock. Or more specifically, the fact that recent historical volatility has risen to more closely approximate what option traders have long suspected.
I suspect this has to do with changes in the pricing contracts associated with metallurgical coal. TCK has moved to monthly pricing rather than longer term contracts, so as to ensure that prices more closely reflect the current market. That’s fine in a rising market. But it means that going forward stock price of TCK will closely align itself with a more volatile revenue stream.
The high premiums (implied volatility 34.1% versus historical volatility of 20.9%) associated with CFP options may be an early warning sign of similar conditions within the lumber market. Not because of CFP contractual arrangements, but because of lumbers’ heightened sensitivity to costs associated with a higher loonie.
If you accept that scenario, then buying puts on CFP makes more sense for conservative hedgers or aggressive bears. Take a look at the CFP July 10 puts recently trading at 35 cents.