CHINA SHEN ZHOU MINING & RES SHZ S
March 23, 2011 - 8:15pm EST by
casper719
2011 2012
Price: 4.80 EPS $0.00 $0.00
Shares Out. (in M): 28 P/E 0.0x 0.0x
Market Cap (in $M): 135 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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Description

I am recommending an option play on SHZ, specifically shorting the October 2.5 strike calls and October 5 strike puts. Given the scale of this play, it will most likely be for the PA/small fund only; however, it's a decently liquid option market considering the stock has a $125 million market cap that should improve if the stock stays hot. The stock itself is extremely liquid demonstrated by the float turning over completely on Wednesday. One may lose a bit on slippage but, the position is tradable.

There is not too much to say about the stock. It spent much of last year around $1 and has been subsequently caught up in the rare earth frenzy despite not having any actual exposure to rare earths. It is actually a miner of Fluorite (not that mining rare earths would be necessarily a big positive). I believe the thesis here doesn't go too much past the naming trifecta of "China" "mining," and implicitly "rare earths". Once it became included in the rare earth grouping, it has stayed there, as price action indicates. There was a headline yesterday about surging rare earth spot prices for last month being up roughly 9x yoy. Illustrating the absurdity, Japan is the largest importer in the market by far and only bought a meager 281 tons at these artificially squeezed of 138k/ton in February.  (We can save Molycorp and its $5 billion market cap, which was up 18% Tuesday for another day).

SHZ has gone through 5 CFOs in 3 years, and unlike a CCME, they aren't even pretending to have meaningful sales or income in the past. This month, Absaroka Capital Management wrote a scathing piece on the company.  See below for a more in depth read:

http://www.absaroka.com/uploads/SHZ_SELL_Report.pdf

http://www.absaroka.com/uploads/SHZ_Letter_032311.pdf

 

After rising 50% in the last 2 days, implied volatility has come down from 200% to only 130%. I have always been a believer that the Black-Scholes model breaks down when you go far out either by underestimating tails or falling into the fundamental financial theory flaw of volatility=risk.

In reality, I believe risk to this trade is a short term volatility spike, or another headline that sends the price soaring, but as shown, when the stock hit $10, it could not hold it for long (1 day). I doubt this would be any different in the future, making a permanent loss on this position (which needs a sustained price 50% above today at $7.50) negligible. Therefore, I think this is generous in favor of a bullish SHZ price, but to be conservative...

...The numbers are fluid, but I offer a rough calculation to show the trade setup:

 At a price of $4.80, on the close, one can short Oct 2.5 calls for $2.45 and Oct 5 puts for $2.25.

  • 50% chance of stock ending October between $2.5-$5, meaning the stock falls on average ~25% = $2.2 gain
  • 35% chance the stock ends at the mid point of $0-$2.5 or $5-$7.5 = ~$1 gain
  • 15% chance of a $10 dollar price = ($2.50) loss

EV Outcome = $1.1/share * 12/$7 on $5 nominally invested capital = ~%40 IRR

 

It would be my preference to short more calls given the obvious downward bias here, perhaps in a 3/2 or 4/3 ratio, scaling in at higher prices above 1/1.

Arguably, there is some risk of being exercised on the calls and the borrow is ~60% on interactive brokers. However, with the offset from the decay, the borrow cost is tenable, and if called, there is such a premium buffer to the downside in the short run on the puts that the trade should still be ok.  

Catalyst

Time
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    Description

    I am recommending an option play on SHZ, specifically shorting the October 2.5 strike calls and October 5 strike puts. Given the scale of this play, it will most likely be for the PA/small fund only; however, it's a decently liquid option market considering the stock has a $125 million market cap that should improve if the stock stays hot. The stock itself is extremely liquid demonstrated by the float turning over completely on Wednesday. One may lose a bit on slippage but, the position is tradable.

    There is not too much to say about the stock. It spent much of last year around $1 and has been subsequently caught up in the rare earth frenzy despite not having any actual exposure to rare earths. It is actually a miner of Fluorite (not that mining rare earths would be necessarily a big positive). I believe the thesis here doesn't go too much past the naming trifecta of "China" "mining," and implicitly "rare earths". Once it became included in the rare earth grouping, it has stayed there, as price action indicates. There was a headline yesterday about surging rare earth spot prices for last month being up roughly 9x yoy. Illustrating the absurdity, Japan is the largest importer in the market by far and only bought a meager 281 tons at these artificially squeezed of 138k/ton in February.  (We can save Molycorp and its $5 billion market cap, which was up 18% Tuesday for another day).

    SHZ has gone through 5 CFOs in 3 years, and unlike a CCME, they aren't even pretending to have meaningful sales or income in the past. This month, Absaroka Capital Management wrote a scathing piece on the company.  See below for a more in depth read:

    http://www.absaroka.com/uploads/SHZ_SELL_Report.pdf

    http://www.absaroka.com/uploads/SHZ_Letter_032311.pdf

     

    After rising 50% in the last 2 days, implied volatility has come down from 200% to only 130%. I have always been a believer that the Black-Scholes model breaks down when you go far out either by underestimating tails or falling into the fundamental financial theory flaw of volatility=risk.

    In reality, I believe risk to this trade is a short term volatility spike, or another headline that sends the price soaring, but as shown, when the stock hit $10, it could not hold it for long (1 day). I doubt this would be any different in the future, making a permanent loss on this position (which needs a sustained price 50% above today at $7.50) negligible. Therefore, I think this is generous in favor of a bullish SHZ price, but to be conservative...

    ...The numbers are fluid, but I offer a rough calculation to show the trade setup:

     At a price of $4.80, on the close, one can short Oct 2.5 calls for $2.45 and Oct 5 puts for $2.25.

    • 50% chance of stock ending October between $2.5-$5, meaning the stock falls on average ~25% = $2.2 gain
    • 35% chance the stock ends at the mid point of $0-$2.5 or $5-$7.5 = ~$1 gain
    • 15% chance of a $10 dollar price = ($2.50) loss

    EV Outcome = $1.1/share * 12/$7 on $5 nominally invested capital = ~%40 IRR

     

    It would be my preference to short more calls given the obvious downward bias here, perhaps in a 3/2 or 4/3 ratio, scaling in at higher prices above 1/1.

    Arguably, there is some risk of being exercised on the calls and the borrow is ~60% on interactive brokers. However, with the offset from the decay, the borrow cost is tenable, and if called, there is such a premium buffer to the downside in the short run on the puts that the trade should still be ok.  

    Catalyst

    Time

    Messages


    SubjectWhy not sell the 5 calls?
    Entry03/24/2011 12:10 AM
    Membertyler939
    I have to agree with majic that if you try to execute on the 2.5 calls, you will most likely do it at a discount to intrinsic value at the time of execution, and they will be exercised the next day.  The 5 calls, on the other hand, have some actual premium.
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