Steel Gets Bent

In our last article (Aluminum Foiled), we mentioned how Alcoa (NYSE:AA) got hammered Wednesday. Of course, U.S. Steel (NYSE:X) took a beating on Wednesday too, and was down nearly another 6% on Thursday. Our Portfolio Armor website was bullish on U.S. Steel earlier this month, but we noted a warning by Gregory Krupinsky and presented a hedge for longs (Steel Trap?). Since then, U.S. Steel has clanked down 13.5%.

Screen capture via YCharts.

Below we’ll look at how that hedge has reacted to U.S. Steel’s slide since and then consider what might come next.

The April 3rd Optimal Collar Hedge:

As of April 3rd’s close, this was the optimal collar to hedge 1,000 shares of X against a greater than 17% drop by late July while not capping an investor’s upside at less than 21% by the end of that time period (screen captures via the Portfolio Armor iOS app).

Screen capture via the Portfolio Armor iOS app.

Screen capture via the Portfolio Armor iOS app.

As you can see at the bottom of the second screen capture above, the cost was negative, so an investor would have collected an amount equal to $170, or 0.5% of position value when opening this collar (calculated conservatively, using the ask price of the puts and the bid price of the calls).

The point of this hedge was that the investor could tolerate a decline of 17%, but no more than that. Let’s see where you’d be had you hedged then and held since.

How The April 3rd Collar Responded To X’s Drop

Here’s an updated quote on the put leg as of Thursday’s close:

Screen capture via Nasdaq.

And here is an updated quote on the call leg:

Screen capture via Nasdaq.

How That Hedge Ameliorated X’s Slide

X closed at $33.88 on Monday, April 3rd. A shareholder who owned 1,000 shares of it and hedged with the collar above then had $33,880 in X shares plus $2,610 in puts, and if he wanted to buy-to-close his short call leg, he would have needed to pay $2,780 to do that. So, his net position value on April 3rd was ($33,880 + $2,610) – $2,780 = $33,710.

X closed at $29.42 on Thursday, April 13th, down 13.5% from its closing price on April 3rd. The investor’s shares were worth $29,420 as of 4/13, his put options were worth $3,875, and if he wanted to close out the short call leg of his collar, it would have cost him $1,510, using the midpoint of the spread in both cases. So: ($29,420 + $3,875) – $1,510 = $31,785. $31,785 represents a 5.7% drop from $33,710.

More Protection Than Promised

So, although X had dropped by about 13.5% at the time of the calculations above, and the investor’s hedge was designed to limit him to a loss of no more than 17%, he was actually down 5.7% on his combined net hedge plus underlying stock position by this point. This is an example of the impact of time value on a hedge designed to protect based on its intrinsic value alone. You can see, too, that the time value had even more of an impact here than in the Alcoa example last time.

What Next?

When we considered this in our Alcoa article, we wrote about the importance of perceptions about the prospects for economic growth and President Trump’s infrastructure stimulus. That holds true for U.S. Steel too.

We also looked at dark pool data from Squeeze Metrics to get a sense of what institutional investors were doing in those private exchanges (we have an affiliate partnership with them, and are compensated if a reader joins the site). But we questioned whether those dark pool traders had an information edge, given the macro news impacting the share price. That uncertainty applies even more in the case of U.S. Steel, as dark pool investors were bullish on it when we posted our hedge for U.S. Steel earlier this month, suggesting they were as blindsided by the beating on Wednesday and Thursday as retail investors.

We are, however, posting an updated dark pool chart to illustrate one point. This chart includes the last 10 trading days, but we’ve highlighted Thursday, so you can see the DPI that day.

Screen capture via Squeeze Metrics.

Remember that the DPI, or Dark Pool Indicator, is a measure of whether institutions are net buyers or sellers of the stock in private exchanges, away from the public markets. The 48% DPI on Thursday for U.S. Steel is a bearish indicator in this context, meaning that dark pool traders were net sellers on the day. Here’s the interesting point though: Dark pool traders were bullish on the other 9 trading days in that chart, including on Wednesday, when X swooned about 10%.

There was a somewhat similar pattern with Alcoa on Wednesday and Thursday, with dark pool traders buying the dip on Wednesday, but bailing on Thursday. Portfolio Armor remains bullish on X though, estimating a potential return of 22% over the next 6 months.

The collar above doesn’t expire until October, so you have time to see what happens here, while your downside is strictly limited. If the stock drops further, you could consider buying-to-close the call leg of the collar to eliminate your upside cap, but only if you think X has a shot at taking out $41 over the next 6 months. Our site’s current potential return sees $35 as a more plausible upside target now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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