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Options Trading: Hedge against a lousy retail season with this South Korean options basket

Posted December 20, 2007

“Looking at LPL’s share price chart, the most likely price path will be a drop to the 61.8% retracement marker some six to eight weeks out at $20.05. At that point it is reasonable to expect a modest rebound.” Sara Nunnally

by Sara Nunnally

Baltimore — (TFN): In a year characterized by booming stock markets around the world, it’s easy to overlook those markets that don’t make it to the mainstream media on a daily basis. Markets like South Korea’s KOSPI, for example. This index has gained over 50 percent year-over-year. And yet, despite what would be an amazing gain in any other year, even conservative investors like Warren Buffett, consider South Korean stocks attractive and cheap.

But the Seoul Stock Exchange has left the stage of emerging market far behind and is now entering that of a developed market.

Analysts have considered the recent surge in the South Korean market a side effect of low interest rates and the cooling real estate market. But there is real economic growth underlying the upsurge: South Korea just revised its GDP forecast for 2007 growth to come in at 4.6 percent. Koreans consider this almost a recession, being used to growth of 5-6% annually.

Market gains as a result of solid growth

Economic growth derives from gains in productivity that are regularly coming in at 4 percent: South Korea, along with Taiwan, has the highest productivity growth of any developed country in the world! Productivity growth of 4 percent means that Korean exporters are becoming more and more competitive against their global competitors. But despite economic expansion and stock market gains, South Korea isn’t a fashionable market internationally. Korean stocks on average trade at 13 times earnings, which for a market with this kind of growth, is nothing short of fantastic.

The main driver for South Korean growth is, of course, the export sector, especially the high technology and automobile industry. But a major engine of growth is China. Like Japan and Taiwan, the big South Korean companies do the R&D themselves, and then get the results manufactured cheaply in China.

South Korea’s economic engine is under new management

With the newly elected South Korean president, Lee Myung-bak (former boss of the Hyundai Engineering and Construction Corp.), winning by a landslide, the end of a decade-long liberal rule in Korea is in sight.

Will Lee Myung-bak be able to follow through with his economic reforms, and roll back business regulations? If he can, it’ll lay out a welcoming mat for foreign investment. But it won’t come in time to prevent some short-term market weakness.

South Korea’s most important exports are electronics and ships — an interesting mix that sets up two investment ideas for this week.

Electronics, or more specifically, semiconductors, have pushed South Korea onto the main stage for global demand. In fact, between 1987 and 1995, major Korean companies increased their total export sales by 602%! Since then, major companies have climbed another 234%. That’s impressive, but also a bit of a warning sign. Korea’s electronic export power is being hit by new competition from other Asian countries, like China and Taiwan.

In fact, both LG Electronics (LPL: NYSE) and Samsung (SSNLF.PK), two of the largest Korean electronic companies, started using some Taiwanese components and products, marking a major shift in philosophy from “Buy Korean” to “We’ve got to stay competitive.”

But that’s not the only issue…

LPL derives about 99.5% of its sales from overseas subsidiaries. Outside of China, the company generates most of its income from the U.S. This holiday season, consumers have to deal with the shrinking value of their dollars and high energy and food costs. Not a good combination for foreign export companies. To entice these beleaguered buyers, companies are forced to introduce steep discounts. That cuts into the bottom line very quickly, and doesn’t even guarantee a sale.

Plus, the company’s fourth quarter is normally its highest revenue generator… from holiday sales, of course. Once January comes around, sales take a huge dive.

South Korea hedged options play

This sets up an incredibly bearish scenario… at least in the short-term. Looking at LPL’s share price chart, the most likely price path will be a drop to the 61.8% retracement marker some six to eight weeks out at $20.05. At that point it is reasonable to expect a modest rebound. Risk to a downside play is represented by the first of our two outlying scenarios, which has price rebounding immediately as the bulls attempt a new high. This effort will fail at $27.02 and then run sideways, oscillating between that high and $24.49.

Our final set up sees support at $20.05 failing. At this point the bears really sink in their teeth, and LPL shares drop back to the vicinity of their 2007 (and 2004) lows at $13.30.

Here’s your recommended play: Purchase LPL April 25.00 Puts (LPL PE), currently available for $400 with a delta of 0.44. These puts have an intrinsic value of roughly $80, leaving your charge for four months time at $320, a reasonable bargain in my book.

Should LPL shares drop to $20.05, these calls would rise to $588, for a gain of 47%.

Buy LPL April 25.00 Puts (LPL PE). Hedge against volatility with LPL April 35 Puts (LPL DG)


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Posted by Sara Nunnally · Filed Under International Investing 

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