- Posted by Richard Croft on August 22, 2010 filed in Options Market
Is this week’s surge in agri-business stocks like Potash Corp. (TSX: POT) and Agrium Inc. (TSX: AGU) overdone? Some analysts think that any price above $140 per share for POT is pure speculation. And yet by the end of the week, POT shares closed at $157.06.
No one believes POT is cheap. Takeover speculation often takes on a life of its own, with companies enticing bids that have no basis in logic.
In the current environment, a speculative frenzy is about the only way to describe the agri-business. Drought induced shortages in Russia have pushed up prices for wheat futures.
Reminds me of the last time agri-companies were setting new highs. Remember the government-mandated ethanol craze that caused shortages in soft commodities like corn and soybeans. But when further analysis calculated the miles per bushel of corn one would expect to get with a typical North American automobile, governments began to re-think the efficiency of using corn for ethanol rather than livestock feed. Warehouse inventories were quickly replenished, and agri-companies quickly fell to more rational levels.
The problem with commodity cycles is that by the time you learn there’s a mania, it’s probably too late. Increasing the likelihood that sans a speculative frenzy, the market will experience a sharp sell-off.
The recent agri-stock runups are already discounting some lofty expectations for future earnings. And if we assume that the primary driver of the current investing theme is the price of wheat today, then the sustainability of the rally in agri-stocks is questionable indeed.
Having said that, the advantage of limited risk entices option traders to play speculative frenzies. Speculating for example, that a POT bidding war will ensue that could take the price to $175 per share or higher. If you buy that, then buy POT September or October close to the money calls.
The POT September 160 calls are trading at $3.65 while the October 160 calls are at $5.75. If the speculative frenzy continues into this week, these calls could double or triple in value. The maximum risk is the cost of the calls.
If you are like me and are more skeptical about the outlook for the agri-business, you could look at AGU bear call spreads. Because AGU is not in play – yet! – it is benefiting from the POT saga without the ancillary takeover noise.
With AGU trading at $72.03, you could sell the AGU Oct 72 calls at $3.60 and buy the Oct 80 calls at $1.00. This bear call spread creates a $2.60 net credit with a maximum risk of $5.40 ($8.00 difference in strike prices less the net credit of $2.60 = $5.40 maximum risk). If AGU, were to fall back both calls would worthless and you would keep the net credit.