During the past several years, base metal miners have been heavily correlated with emerging markets, and specifically to China's economic growth. This is because China has provided an incredible amount of demand for construction metals, such as copper and iron ore. The more China invests in its infrastructure, the better the business environment for these miners.
So it comes as no surprise that as investors have lost faith in China's economic growth, stock prices for miners such as Freeport-McMoRan Copper & Gold (NYSE: FCX), BHP Billiton (NYSE: BHP) and Vale (NYSE: VALE) have been under pressure.
But in recent weeks, these stocks have begun to trade higher.
Last week, Bloomberg reported an uptick in Chinese manufacturing, with the country's preliminary purchasing managers' index rising to 50.1 from 47.7 in July. Keep in mind, a reading of 50 indicates no growth in manufacturing. So August's number essentially represents a flat but improving manufacturing environment after months of contraction.
But despite the anemic recovery in manufacturing, investors are once again shifting their sentiment on China's growth -- and that may be a major bullish factor helping to boost share prices for base metal miners.
Earlier this month, a gauge of energy producers in China moved up 5.7%, the largest gain since last September, and Chinese equities rose to their highest level in almost two months. Additionally, stocks of Chinese real estate companies, financial firms and retail companies should move higher as investors begin to account for the fact that China's slowing growth may be reverting back to a healthy expansion period.
Investors had been largely discouraged with the decelerating growth in China, and that led to a significant amount of capital rotating out of Chinese equities and related stocks. In fact, managers became so bearish on China's prospects this year that the area may now be primed for a massive short squeeze.
A short squeeze occurs when a large number of traders have short positions in a stock that begins to trade higher. As prices increase, losses mount, and the short sellers are forced to cover their positions. This creates more demand for the stocks, sending them sharply higher in a vicious cycle. If this happens with China-related stocks, we could see them move up fast.
Collecting 30% Income a Year As China Moves Higher
At this point, expectations for Chinese growth appear to be shifting back toward a more positive perspective. This is causing Chinese equities, and related stocks like base metal miners, to trade higher. Considering the fact that China is such an important part of the global economic picture, this shift in sentiment could take some time.
Today, I want to set up a bullish income play for FCX -- a stock that should continue to move higher as optimism returns for China.
FCX is a very profitable miner with a steadily growing business. While earnings per share (EPS) are expected to decline this year to $2.42 from $3.22 in 2012, estimates for 2014 are for a nearly 30% increase in EPS to $3.11 and an 18% increase in revenue to $24.6 billion.
The stock is currently trading near $30.60, which is just 10 times expected earnings for 2014. Given the growth prospects for the company, this is an attractive valuation. FCX has been trading higher for the past two months, and I expect the company to continue to rebound as sentiment shifts for China's overall growth.
To generate income on this bullish play, I want to sell FCX Oct 30 Puts near $1.25. Keep in mind, for each contract that we sell, we are obligated to buy 100 shares of FCX at $30 if the stock is trading below $30 when the puts expire on Oct. 18.
Since we have an obligation to buy 100 shares at $30, and we are receiving $1.25 per share, or $125 per contract, for accepting this obligation, we will need to set aside an additional $28.75 per share, or $2,875, in case we are called upon to buy the shares.
So, assuming our puts are not exercised, the $125 in income against the $2,875 represents a 4.3% yield in the next seven weeks. If you set up trades like this throughout the course of the year, you would be able to generate 30% per year.
Now, assume FCX trades back below $30 and we are obligated to buy the shares. I would still be happy with this trade. This is because we get to buy this already attractively valued stock at a 6% discount to recent prices. Additionally, FCX pays a quarterly dividend of 31 cents a share. Buying the stock at a net cost of $28.75, our dividend yield would be 4.3%, and we can also expect capital gains as the stock moves higher.
I'm excited about this trade because it allows us to generate a very attractive rate of return on our capital if the puts are not exercised, along with the opportunity to buy a quality dividend stock at a significant discount if the puts are exercised.
This article was originally published at ProfitableTrading.com
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