Monday, March 10, 2014

VALE: Downside potential, upward correction looms

Update 3/28/2014: VALE closed above its exit signal level on Thursday and confirmed the exit signal today. I've closed my options position for a loss.

VALE shares rose by 9.1% over the 17 day life of the bear position. The options produced a 200% loss on risk.

The symbol is correcting upward in the midst of a downtrend. It hit the low point of wave 3 on March 14 and is presently tracing out wave 4 and will begin wave 5 to the downside soon. 

The options, a synthetic short futures, expire June 21 and would need to be rolled into a new position at least a month earlier. That gives very little time for wave 4 to complete its work and then reverse back to profitable levels.

An exit is the prudent course, and that's what I've done.

I've marked the level of the exit signal ($13.25) on the chart in red, and the entry signal level ($12.60) in green. It's clear that VALE executed a whipsaw.

It's upward course must stop short of the beginning of wave 3, at $14.44, giving it a maximum 4.9% upside potential above today's opening price. Under the Elliott rules it could reverse at any point below that level, ending wave 4.

In retrospect, the warning signs were there. The title says it, "upward correction looms". The problem, as is often the case with options, is one of timing, and can be solved by either extending the lifespan of the options for synthetic futures positions, which can lose money incredibly fast, or to reduce the size of my synthetic futures positions so if they do turn in the wrong direction, the losses are less. Or, I could simply not trade synthetic futures, which are both unhedged and leveraged, a potential explosive mixture. Must ponder this.

Click on chart to enlarge.
VALE 5 months 4-hour bars

Update 3/11/2014: VALE resumed its decline and I've opened a bear position, structuring it as a synthetic short future expiring in June, long the $12 put and short the $12 call.

Update 3/10/2014: I've added VALE to the Watchlist rather than taking the trade. The price closed down for the day, but it began an upward drive visible on the five-minute chart two hours before the market close. It remains a potential trade, but I'll need to see some downside momentum at the close before I place the order.

Vale SA (VALE) has been on a slide for more than three years. A bear signal on Friday, confirmed in trading today, marked a resumption of the downtrend following an upward correction of nearly a month's duration, from late January to late February.

The usual cautions about jumping into a long-running trend apply to VALE. However, the chart suggests that there is sufficient room for the price to drop more than 30% before the decline ends.

That's not to say that there won't be reversals along the way. In fact, an upward correction may be coming due. No stock moves in a straight line for any amount of time. All charts are filled with staircases that reflect the changing moods of the marketplace.

The Chart

Elliott wave analysis puts VALE in the middle phase of the final leg of a decline from $17.14 beginning Nov. 6, 2013. The middle phase began Feb. 27 from $14.44.

Taken together, the two reversal points suggest that VALE will move into an upward correction sometime in March, staying well below $14.44. Once that wave is complete, VALE will continue its downward course.

Click on chart to enlarge.
VALE 8 years 3-day bars (left), 90 days hourly bars (right)
I can set no targets for the near term. The middle phase, wave 3 to the downside, within the final leg, wave 5 {+1} to the downside, has already set a lower low. It could call it quits from $12.61, the low so far today as I write, with two hours before the closing bell. Or it could push on down for a significant distance.

The prudent trader will wait for the wave 4 correction and then jump in. Traders more comfortable with risk will jump in now and count on their exit rules to limit the loss if the reversal to the upside comes quickly.

Over the longer term, however, the price will eventually fall below $8.80, the Great Recession low set on Nov. 20, 2008 at the end of wave A {+4} following a rapid decline beginning May 19, 2008 from $44.15.

The subsequent wave B {+4} peaked on Jan. 18, 2011 at $37.25. Under the Elliott wave rules, wave C {+4} must move below the end of wave A {+4}, which is also the beginning of wave B {+4}.

My count puts VALE in wave 3 of 5 {+1} of 3 {+2} of 3 {+3} of C {+4}.

Odds and Yields

VALE has completed 18 bear signals since wave C {+4} to the downside began on Jan. 18, 2011. Seven were profitable, on average yielding 6.6% over 33 days. The unprofitable trades lost 4.8% over 14 days, on average.

Despite the prevalence of a tendency toward whipsaws, VALE's yields from successful trades were high enough to give a positive win/lose yield spread of 1.8%.

The more recent wave 3 {+2} to the downside, which is still underway, has completed two bear signals, both profitable, on average yielding 1.5% over 27 days.

The Company

Vale, headquartered in Rio de Janeiro, Brazil, is the second-largest mining corporation in the world, producing a wide range of industrial metals and fertilizers. It is the 5th largest holding in EWZ, the exchange-traded fund that tracks the Brazilian market, accounting for nearly 10% of net assets.

Analysts collectively are neutral about Vale's prospects, coming down with a zero percent enthusiasm index.

The company reports return on equity of 30%, with long-term debt amounting to 66% of equity.

Vale's earnings hit a peak in the 1st quarter of 2011 and then fell steadily into the 3rd quarter of 2012. From there the company's earnings began to recover, but the peak so far has only been a bit more than half of the prior peak.

Earnings have surprised to the downside seven times in the last three years, most recently in the 4th quarter of 2013, the most recent earnings reported, and to the upside four times.

The earnings yield is 9.29%, higher than 62% of other metal miners, and the company pays a semi-annual dividend yielding 0.86% annualized at current prices.

The stock is priced at 11 times earnings and also sells at a premium to sales. It takes $1.40 in shares to control a dollar in sales.

Institutions own 14% of shares. The stock goes ex-dividend in April for a payout of 5.44 cents.

Liquidity and Volatility

VALE on average trades 23.1 million shares a day and supports a moderate selection of option strike prices spaced a dollar a part, with open interest running to four figures near the money and a front-month at-the-money bid/ask spread on puts of 1%, compared to 0.3% for the S&P 500 fund SPY.

Implied volatility stands at 42% and has been rising since late February. VALE is nearly three times more volatile than SPY.

Volatility is in the 48th percentile, in the middle range, suggesting that short shares or an options equivalent, have the best chance of success.

Options are pricing in confidence that 68.2% of trades will fall between $11.10 and $14.14 over the next month, for a potential gain or loss of 12%, and between $11.89 and $13.35 over the next week.

Options are trading actively today, with calls running at more than double their five-day average volume and puts at 28% above average.

Decision for My Account

I intend to open a bear position in VALE, structured as synthetic futures. Such a position is built from options: A long put and short call with an identical strike price and expiration date.

I'll make the trade today if VALE shows downside momentum in the half hour before the closing bell. Otherwise, I'll put it on the Watchlist and try for a fill another day.


My shorter-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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