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Exploit the mining sector but hedge the risk with judicious spread bets

by Nick Sudbury

The mining sector offers rich rewards for those who can handle the risks. One of the most striking aspects of the markets is the significant disparity in the performance of the different sectors. In the last three years, the biggest casualties have been the likes of the banks and general retailers, which have lost around 30% of their value, while at the other end of the spectrum the mining sector is up an incredible 107%. To put this into context, over the same period the FTSE 350 has risen just 4%.

The strength of mining stocks reflects the boom in the commodity markets, but talk of a possible bubble is beginning to take its toll. In mid-May, for example, the sector index peaked at an all-time high of just over 30,000 but since then it has dropped back sharply and at the time of writing was trading 30% lower.

‘Mining stocks can yield dazzling returns but the pay-off is occasional bouts of severe volatility,’ says Martin Slaney, head of derivatives at GFT Global Markets. ‘Having a structured trading plan and the discipline to stick to it really becomes essential when trading stocks with these characteristics.’

The sector index

One of the attractions of spread betting is it opens up the possibility of trading both the sector and the constituent share prices. An area like the miners tends to be dominated by stock-specific news, so the diversified cap-weighted index may provide a clearer indication of the true underlying trend.

‘Historically the mining stocks do well in the third quarter as it is the run up to their reporting season,’ says Sandy Jadeja, chief market strategist at ODL Securities. ‘At the moment, however, the sector index is making lower lows and lower highs on a weekly basis, with the RSI yet to give any indication of the market being oversold.’

Jadeja has spotted the development of a potentially bearish head and shoulders pattern, which suggests to him a further 3% decline to a short-term bottom, followed by a 5% to 7% rally and then a larger turn to the downside.

When looking at a particular sector, it is also important to keep in mind the bigger picture, especially considering that the mining stocks now make up around 13% of the FTSE 100 index.

‘The FTSE has risen 103% from its low of 2003, with the 50% retracement coming in at 5,015,’ says Jadeja. ‘If the index doesn’t manage to find support at this point then it could well fall to the 62% retracement level of 4,600 by October.’

The mining sector is of such significance that even those trading the FTSE 100 index direct will need to think carefully about its potential influence.

‘If someone has a position in the FTSE but is looking to hedge some or all of that risk on a particularly mining-dominated news day, it might make sense to trade in the opposite direction either on the sector or on just a couple of the main players such as Rio Tinto (RIO) and BHP Billiton (BLT),’ says Slaney.

A mixed bag

David Jones, chief market strategist at IG Index, says some of the mining stocks still look relatively strong while others appear very weak. ‘This implies a pairs trade could work quite well, with a long position in a strong stock like Xstrata (XTA) and an equivalently sized short in a weak play such as Antofagasta (ANTO).’

Looking at the charts, it seems Antofagasta has entered a clear downtrend with the drop below £6 indicating further possible falls, while Xstrata has been more resilient. The reason for combining the two in a pairs trade is it eliminates the market and sector risk with the profit or loss driven purely by the relative performance of the stocks.

As long as Xstrata continues to do better than Antofagasta then the pairs trade would make money regardless of whether the sector rises or falls. The downside to this approach is it requires two positions, which means twice the capital and twice the cost. It is also important to appreciate the combined position would make a loss if the relative performance went the other way.

Alternative strategies

Those who think there will be widespread weakness among the miners could use a variation of the pairs trade to short the sector index while going long on one of the stronger stocks like Xstrata. The key with this type of approach is to match the size of both legs of the trade.

‘Xstrata is currently trading at around £30, or 3,000 points, while the mining sector is up at 22,000. This means that a trader betting the minimum of a pound a point on the index would need to use a stake seven times larger on the stock. In total the combined position would therefore need an initial margin balance of about £5,000,’ says Jones.

More bearish traders could just short the sector index and limit the risk by using an appropriate stop loss. With the market trading at 21,400 and the recent high being 22,000 this would suggest anyone looking to run the position for several weeks would need to be prepared to risk a possible 600 points. At the minimum bet size of a pound a point this would equate to a maximum loss of £600. It is possible a trailing stop like those available from IG and GFT could potentially reduce this by locking in any initial profits.

A normal stop is set at a fixed level whereas a trailing stop is positioned a certain number of points behind the market. This means if the price initially moves in the trader’s favour the stop would automatically move up behind it to lock in the gain. Even if the market subsequently reversed enough to trigger the stop the final loss would be reduced by the extent of these early profits.

If a trader thought the mining sector would fall heavily and that this would drag down the wider index then it would be logical to short the sector and go long on the gold price in anticipation of a flight to quality. Over the last 18 months both have produced very similar returns yet gold has certainly been the less volatile of the two markets.

A difficult call

Mining stocks are currently trading 30% below their highs of mid-May. The reason for this recent weakness is the growing uncertainty as to whether the emerging markets can maintain their demand for natural resources in the face of the slowdown in the developed economies.

‘It is difficult to short the mining stocks as there is a lot of talk of consolidation in the sector and it would only take one of these stories to come to fruition to spark a rally,’ says Paul Chesterton, senior sales trader at CMC Markets. ‘It is also tough to be long given the size of the shakeouts.’

The significant recent correction is tempting some investors back into the sector. It appears the more bullish are looking to go long on the dips in the hope of a recovery and further consolidation. This potentially lucrative strategy paid off in early August when Xstrata announced a hostile bid for Lonmin (LMI). The latter’s shares jumped 50% on the day, while the sector index gained 2.6%.

‘One way to enter these volatile areas is to average in, so someone looking to bet £20 a point could start with a £5 stake and then increase it if the position moves into profit,’ says Chesterton. ‘It is always a good idea to have a stop in place, which with this kind of averaging in approach should be based on the amount of money someone is prepared to risk losing on the overall exposure.’

Risk management

Normal stops are free but they only take effect at the next tradable price once the order has been triggered, which leaves positions vulnerable to the risk of slippage. The alternative is to pay a small premium on the spread for the extra security of a guaranteed stop. As the name suggests, these are guaranteed to take effect at the stipulated level irrespective of whether the market actually trades at that price.

There are several reasons why it might be worth considering paying for this extra protection. For those going long there is the risk metals prices may experience a sharp fall overnight in the Australian and the Far Eastern markets. This would probably prompt a significant de-rating of the mining stocks during the opening auction on the LSE, with the share prices gapping down from the previous night’s close.

The biggest risk for traders looking to short is news of a bid leading to a general upgrading of the sector. Such an event would tend to cause prices to gap up resulting in significant slippage on the stop and a much larger loss than was initially envisaged. This could not happen with a guaranteed stop like those available from IG and CMC.

Those trying to maintain a longer-term exposure to this area of the market may be able to dampen down the volatility by allocating their capital across a mixture of mining companies and the related commodities. This is because the stocks themselves tend to be more volatile than the underlying natural resources which they mine.

‘People who are looking to trade the miners on a mid- to long-term basis may find it worthwhile splitting their portfolio between stocks and commodities such as copper, gold or oil. In that way they are eliminating some of the bottom-line corporate risk while still benefitting from the move in the commodity itself,’ says Slaney.