Options Update: Short Strangling Kinross Gold Corp. (KGC)

KGC

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Kinross Gold Corp. (KGC: sentiment, chart, options) has attracted quite a bit of attention in recent weeks. Shares of the mining firm became quite popular when gold prices flirted with $1,000 an ounce, but with the malleable metal pulling back amid profit-taking, KGC has since lost some of its luster. J.P. Morgan yesterday expressed its belief that the stock has further to run, upgrading KGC to "overweight" from "neutral." But, while analysts at Dundee maintained their "buy" rating, the brokerage firm cut its price target on the shares to C$28 from C$29 per share.

Speculation among options traders has taken a bearish turn in recent weeks. KGC's Schaeffer's put/call open interest ratio (SOIR) of 0.56 ranks above 95% of all those taken during the past year, highlighting a preference for puts over calls among options with less than 3 months until expiration. Put options are popular once again today, as nearly 4,000 KGC puts have traded thus far, more than tripling the stock's average daily put volume and placing the shares on our Intraday Volume Explosion List. The most popular option is the May 12.50 strike, with some 2,900 puts changing hands before noon. However, digging into the activity reveals that there is certainly more than meets the eye to this swelling put volume.

The Anatomy of a Kinross Gold Short Strangle Position

Digging into today's volume, I noticed that several of the larger May 12.50 blocks traded at the bid price of $1.05 at about 10:11 a.m. Eastern - suggesting that the options were sold to open, or the initiation of put-sell positions. However, these trades were also marked "spread." Delving deeper, I found the other half of the spread trades at the May 17.50 call, changing hands with a bid price of $1.20. Assuming that these contracts were all part of a larger trade and that both sides of the trade were sold to open, we are looking at the initiation of a short strangle position.

A short strangle is a neutral trading strategy designed to take advantage of high option premiums and periods of consolidation for the underlying shares. Think of such a trade as combining a put sell and a call sell into 1 position. Basically, the trader needs the underlying stock to remain between the sold strikes through expiration in order to retain the entire premium received on the position. Alternately, the trader can also benefit from time decay on the options, choosing to buy back 1 (or both) legs of the position at a later date for a cheaper price - thus pocketing the difference. The risk is that profit is capped at the premium received by selling the options, while potential losses are theoretically unlimited.

Breaking down the KGC short strangle position, the trader sold 2,000 May 12.50 puts at $1.05 for a total credit of $210,000 -- ($1.05 * 100)*2,000 = $210,000. Simultaneously, the trader sold 2,000 May 17.50 calls at $1.20 for a total credit of $240,000 -- ($1.20 * 100)*2,000 = $240,000. Adding the 2 together, we arrive at a credit of $450,000 for the entire short-strangle position.

There are 2 potential outcomes for this trade. In the first outcome, the trader needs time decay to decrease the price of the options to such a degree that it becomes profitable to repurchase the sold contracts at a lower price, thereby allowing him to pocket the difference. Currently, implied volatility on the May 12.50 put rests at 86%, while implieds on the May 17.50 call arrive at 80%. Both readings are well above KGC's 3-month historical volatility of roughly 75%, indicating that options are relatively expensive at the moment and lending some credence to this scenario should these premiums move closer to their historical levels.

In the second outcome, the trader needs KGC to remain between the 17.50 and 12.50 levels through expiration on May 15. Such stagnation on the technical charts would allow the trader to keep the entire premium received on both the sold calls and the sold puts. Mining stocks have been considerably volatile in recent weeks - hence the higher implieds mentioned above - so holding the options through expiration could be considerably riskier. That said, let's take a look at the stock's technical and sentiment backdrops for any drivers that could potentially impact this position.

Getting Technical

Technically speaking, KGC has been particularly vulnerable to profit-taking in gold trading during the past couple of weeks. The stock has plunged more than 19.5% since hitting a short-term peak at $19.64 per share in mid-February. The pullback seems to have stalled in the 15-15.50 region, which is home to KGC's rising 20-week moving average. The 15 level is also home to former resistance, capping the equity's advances for much of 2007 and creating an area of chart congestion in the latter half of 2008.

Meanwhile, the stock's 10-week moving average has rolled over in the 18 region, and could provide overhead resistance for KGC. Additionally, the 17 level is home to a 50% retracement of the stock's March 2008 high and its October 2008 low. Such retracement levels can often create technical resistance that is difficult for the shares to move beyond.

In terms of today's trading example, the 17 level and the declining 10-week moving average should help to keep KGC from moving beyond the sold May 17.50 call. Meanwhile, there is plenty of padding between the equity and the sold May 12.50 put. What's more, the 12.50 level is home to prior support for KGC, having bolstered the equity for much of 2007. This area could be key to the aforementioned short-strangle position, as a break below the 15 level could send KGC down for a quick test of this long-term support.

The Sentiment Drivers

Outside of the options pits, sentiment leans toward the bullish end of the spectrum. Specifically, 7 of the 12 analysts following KGC rate the shares a "buy" or better, with no "sells" to be found, according to Zacks. Meanwhile, Thomson Reuters reports that the average 12-month price target for KGC rests at $21.29 per share - a 34% premium to the stock's current trading range. This configuration leaves the security vulnerable to additional price-target cuts or analyst downgrades that could send KGC sharply lower.

What's more, short sellers have largely ignored the equity, as roughly 1% of the stock's float is sold short. This lack of short interest points to a distinct absence of potential short-covering support in the event of a continued decline for the security.

The Verdict? Looking at the stock's technical and sentiment backdrops, there is clearly more downside risk for KGC than there is potential for the shares to rally. Wall Street analysts are beginning to show signs of doubt, as evidenced by Dundee's price-target cut, and a reversal below $15 per share could attract short sellers to the equity. Meanwhile, technical resistance at the 17 level and the stock's 10-week moving average provide quite a hurdle to any rally attempts from the shares.

The biggest risk for the May 17.50 call/May 12.50 put short-strangle position could be the put side of the trade. A breach of the 15 level could send KGC sharply lower. But, while the indicators seem to support the aforementioned trading idea, I would personally prefer buying an April or May 20 put to take advantage of this rising downside risk in KGC shares - I just don't like the idea of potentially unlimited losses.