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Goldman Sachs Hails Vale

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Upgrade sparks fence option play.

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Triggering Option Play

A research note out of Goldman Sachs (GS) today seems to have sparked option activity, if not the stock of Brazilian mining company Vale (VALE). Goldman upgraded its rating from neutral to buy and also increased its price target to $31 from $28 a share. The note also gave a specific option strategy as a recommended way to play a price increase.

Specifically it suggested selling the December $21 puts and using the proceeds to help finance the purchase of a like amount of the December $26 calls; the trade can be done for about $0.25 net debit. Not many seem to have followed that advice specifically as only a few dozen contracts have traded in those strikes.

Going Long for a Long Time

But one strategist must have liked the concept enough to apply it to the longer term, and used the January 2011 LEAPs. The chosen play was to sell 10,000 of the $20 puts and bought 10,000 of the $25 calls for a net debit of $1.10 for the combination.

The position is obviously very bullish, it starts with an 85 delta, meaning that every one contract combination is equal to being long 85 shares. As the stock price rises, the on-the-calls delta will increase and could eventually approach 1.0 or the equivalent of being long the stock.

Of course, as shares decline, the delta on the puts would increase and again the effect will be to essentially be outright long the stock -- meaning losses could mount quickly as the stock could theoretically go to zero.

Getting on the Fence

The advantages of using this type of option play, which is sometimes referred to as a fence, are lower capital requirements than buying the underlying shares and the larger cushion it provides on the downside. That is, if shares of Vale are at $20 at the 2011 expiration -- a $5 or 20% decline -- the loss would be the initial cost of $1.10. Which is a 100% loss.

But in dollar terms, this strategy offers a slightly more conservative approach with a comparable risk/reward profile to owning the stock.

Brazilian stocks have come in vogue following its winning bid to host the Olympics, to say nothing of the general popularity of commodity based plays. Using this type of fence-option strategy might be a good way to play other names such as Parabas (PBR) in sector.

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No positions in stocks mentioned.

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