Elevator pitch: What if I told you there was a trade that would hedge your whole book to a Chinese correction AND had the idiosyncratic risks that suggests it probably may just make 7x anyway… Would that be something you’re interested in!?!
Introduction: Forgive me for doing the Hugh Hendry to kick off, but I get a buzz out of this idea. The following piece is on FMG AU, the Western Australian miner who’s HQ I live adjacent to in Perth, Western Australia. Previously, I wrote a post on FMG here in 2012, I had been bearish iron ore for a while and the strategy worked out well. If the success of that early trade is anything to go by, then this could be a cracker. Forgive the mediocre quality of analysis, at the time I was very green and still working out my process.
I am an extremely average salesperson, but I think my grasp of logic and reason make up for it… So now that I’ve given you the sales pitch, let me indulge you with the analysis!
Hypothesis: Due to the comprehensively low volatility environment we find ourselves in, idiosyncratic opportunities are significantly mispriced. To invert the old adage, the receding tide runs all boats aground!
First Principle: Our first principle, or presupposition if you will, is that iron ore is the first derivative of China’s economy. Thus, following this logic, the companies most levered to iron ore will be the best expressions of the thesis. So the logic goes like this… If China’s economy rolls over, then iron ore will fall and FMG AU will be impacted most adversely.
Fundamental Macro Context: Presently, market participants and geopolitical analysts are parsing the words of President Xi’s speech at the 19th National Congress of the Communist Party of China, looking for hints of what the future holds for China. Some seem to think that now Xi is so well entrenched that he may be confident enough to take the risk to delever the economy. I am completely agnostic, as I have no predicitive function in that analysis. In fact I am ambivalent to the growth prospects of China.
What do concern me are the probabilities, and in the following analytical framework I hope to lay out the reasons for my conclusions as to what the risk reward proposition is, the probabilities and why this is a positive expected value trade.
Fundamental Equity Context: It’s simple, FMG is the most financially and operationally levered stock to the iron ore price. Principally, because the quality of their ore is not 62%Fe and thus, they likely have to pay penalties over and above.
As you can see in the below chart, FMG is the most financially levered to an iron ore price drop with a cost of production of USD ~ $57/t, whilst they are also the most operationally levered with a cumulative seaborne iron ore production somewhere close to 1300mt.
CHART 1: Iron Ore Miners Cost of Production & Cumulative Production
Commodity Context: Iron ore is still within the grips of a long term bear market, one which I was able to correctly anticipate back in 2010. Relief since the late 2105 bottom has been a function of Chinese stimulus, which seemed to directly flow into commodity prices by way of construction and thus steel production. Indeed, it’s only reasonable to expect the causality to flow the other way.
CHART 2: Iron Ore Weekly Price Chart
Equity Context: Since that bottom, FMG has meaningfully outpaced iron ore, as a function of its leverage.
CHART 3: FMG (blue) vs Iron Ore (orange) Normalised as at Jan 2016
Intermarket Analysis: Similarly, FMG has also outpaced its Australian peers with much lower cost profiles RIO & BHP. Both have only managed to outperform the commodity marginally.
CHART 4: FMG (blue), Iron Ore (orange), RIO (light orange), BHP (yellow) Normalised as at Jan 2016
Technical Analysis: FMG is forming a top-like pattern with $4.50 looming as the support. Classical pattern traders might call it a head and shoulders with a sloping neckline, but typically, what is the most obvious is best. Presumably, the reasoning for such a level being meaningful is that new longs will likely look to cover as new lows set in and a new trend takes force. Whilst technicals would logically seem to have unreliable claims upon reason, the other reliable method of understanding reality — experience — suggests otherwise. Thus, I hypothesise that objective and intersubjective technical methods work because humans are prone to patternicity and other type 2 errors, and so they become self-fulfilling. With respect to the below chart, support is indicated by the red horizontal range, if breached, the propensity for sustained selling is likely.
CHART 5: FMG Technical Support
Historical Mean: Further, as we look back at a monthly price chart, we can see that $4.50 is roughly the mean of the volume at price historical distribution on the left axis.
CHART 6: FMG Monthly
Bimodal Distribution: Zooming in once more to the fortnightly price chart, we can see the bimodal nature of historical prices on the left axis, which should arguably suggest that FMG is unlikely to have normally distributed price action in the future. Thus, an option seller using a model which prices options off a normal probability distribution will more than likely be misled, if the future looks anything like the past.
CHART 7: FMG Fortnightly
Implied Volatility: Which leads us to FMG’s implied volatility. Yesterday, when I clipped this chart, FMG’s implied vol was in the 6th percentile over 10 years at 30.46. Albeit, that percentile data might be slightly skewed given the single low data point in 2009 of 13.92 is wrong. Further, over the last 5 years, FMG’s implied vol is in the 3rd percentile of observations.
CHART 8: A Decade of Implied Volatility Data
Realised Volatility: Arguably, this is anomalous, and doesn’t comport with the facts presented here. But why has it happened? This opportunity exists for two different kinds of reflexive reasons: behavioural and mechanistic. Behaviourally, implied volatility tends to follow realised due to recency bias, which is the tendency to overweight recent data. Mechnistically, implied volatility tends to follow realised volatility, this is because options buyers delta hedge according to daily or weekly moves and are unwilling to buy and bid up implieds if there’s no volatility to realise. Together, they can form a self-reinforcing virtuous cycle that otherwise is referred to as reflexivity. With this in mind, it is unsurprising then, that FMG’s realised vol is particularly low, around 1 standard deviation below the mean of historical vols.
CHART 9: Realised Volatility:
Key: -1σ (green line), mean (green dotted line), 1σ 2σ 3σ (red dashed line)
Implied vs Realised: Looking at the last 40 months of data in interactive brokers, we can see that at 29.6% implied is presently significantly below the 200 day realised vol of 41.3%… Which had been as high as 67.8% in May 2016!
CHART 10: Implied (white), 30d Realised (orange), 200d Realised (purple)
Skew: Volatility skew shows the difference between implied volatilities of options against their moneyness – how in or out of the money they are.
It can suggest a few things:
- Volatility Smile – shows that out-of-the-money volatility is higher than in-the-money volatility.
- Volatility Skew – shows that puts are cheaper than calls or vice-versa, and thus, suggests where the options market is hedging directionally.
For the December skew below, we can see that calls are priced relatively cheap vis a vis puts, which may allude to the options market’s estimate of directional risk.
CHART 11: December Skew
Volatility Timing Model:
I made a volatility timing model to signal alerts when certain conditions are met and it is a favourable environment to get long vol. It is difficult to test its empirical reliability due to lack of options data, because I don’t yet know how to layer it onto bloomberg data… Nevertheless, it’s was what alerted me to this trade recently, so its job is done!
Expressions: There are various ways to express this trade, here are some…
- Short the stock outright and keep an eye on iron ore as one’s guide.
Sizing: I wouldn’t size much more than 250bps of one’s book.
- Buy 3m FMG strangle @ 105% & 95% moneyness and roll quarterly.
Delta hedging: it’s path dependent, so hedge accordingly.
Backtest: With a 50% win/loss ratio and a positive equity curve (without hedging), it’s arguably safe to assume that entering at these vols will suggest a higher probability of gains
- Buy June expiry $4 puts for $0.27
Originally, I priced this up as a $4/$2 put spread, but cheapening it with the put leg at 2c is almost pointless… I’d rather buy it for 2c! The r/r of the put spread was up to 7x, to give some idea.
- Buy 9m OTM $2 puts
Theoretically, they cost 2c!?!
And that’s my two cents!
If you made it this far, thank you for reading.
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