An inside look at why we rejected CLF for a bullish recommendation
Our traders are stalking a lot of different stocks throughout the week, but not every potential trade idea develops into a formal recommendation to our subscribers. Whether it's the break of a key technical level, an unexpected news announcement, or an unfavorable options pricing environment, this regular feature will shed some light onto the factors we view as "dealbreakers" to otherwise intriguing trade setups.
Today, Schaeffer's Senior Trading Analyst Bryan Sapp shares his analysis on one stock he was considering -- but ultimately passed on: mining and metal stock Cliffs Natural Resources Inc (NYSE:CLF).
I've been looking to trade CLF from the long side. Among the things I like:
- The stock's huge outperformance, with CLF up nearly 600% year-over-year.
- There's a nice flagging pattern near the equity's multi-year highs.
- Short interest recently hit an all-time high. While it's come back sharply, almost 23% of CLF's float is still sold short.
- CLF reported worse-than-expected earnings in November, but the stock completely shrugged it off and ripped higher -- a potential sign of excessive pessimism.
- The equity's options are currently as cheap as they've been in the past year.
- CLF sports a Schaeffer's Volatility Scorecard (SVS) of 99, suggesting the options market has underpriced the equity's ability to make big moves on the charts over the past 12 months.
Despite all of
the extremely positive Expectational Analysis® drivers listed above, CLF just didn't quite pass the test for me as a long-premium trade. For one, CLF is currently trading right in the middle of a volatile range. In a matter of only three days, CLF rallied from $8.37 to nearly $10 per share. However, it's currently near the middle of that range.
As an option buyer, you almost always want to initiate new directional trades at or near inflection points. In this case, however, CLF is about 7% off the recent highs and lows. There's a good chance that the shares merely chop around in this area -- and that's a situation that you don't want to be in when you're long option premium.
Additionally, you'd have to risk too much on a long trade, as you would most likely want to stay in the trade so long as CLF remained above its recent swing lows near $8.30. This is just too much to risk, when in a leveraged instrument for a short period of time -- considering I had been looking to trade weekly 1/27 options on CLF.
In addition to the recent choppy price action, CLF also appears -- at least for now -- to be making a higher low, after its recent push to $11 in December. This higher low, should that $10 area hold as resistance, could be a sign of a change in trend for the shares.
Lastly, there are some significant potential options-related headwinds in place for CLF. The 9, 9.50, and 10 strikes have huge open interest on the call side, looking out multiple weeks. This open interest could serve as short-term speed bumps for the shares, and could cap any significant moves higher going forward.
This Cliffs Natural Resources Inc (NYSE:CLF) trade was a great example of a setup not being as attractive as it may appear on the surface. Always pay attention to your required risk for staying in a position, and then look for a potential reward that’s a multiple of that risk. I, personally, like to use at least a 3x potential reward for every position. In this instance, it just doesn't make sense to me, given all of the factors listed above.
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