New Trade ABT – Buying Call Diagonal to Play the Next Bounce

by Enis October 23, 2012 11:01 am • Commentary

It might be hard to believe, but Abbott Labs is in the elite group of companies in the world with over a $100 billion market cap.  Since it’s generally viewed as a boring health care company, no one pays the stock much attention.  But it caught my attention last week when the stock fell 10% in a few days after bad earnings and then a drug trial (for kidney failure) ended because of safety issues.

To get a sense for how little this company usually moves, here is the 15 year monthly chart:



The recent breakout above the $60 level was important, because $60 served as resistance throughout 2007 and 2008.  I view that as very strong support going forward.

But the real reason ABT caught my interest is that it’s very cheap.  I have been scanning the various sectors for value over the past few months, to assess how much upside this market had, and health care is the only sector that offered decent risk/reward on the long side in my view.  With the 60 point selloff in the SPX that we’ve had, I view the risk/reward for a long entry here as much better than in the past month.

Within health care though, ABT stands out.  It’s a 13 P/E stock that pays a 3% dividend yield, and consensus estimates for 2013 and 2014 earnings growth are around 6%.  That’s better growth and similar valuation to its health care peers.  Here is the chart of ABT P/E over the past 3 years:



The recent selloff has sent valuation back to its midpoint.  Meanwhile, consumer staples valuations are near 3 year highs.  Safe havens are in high demand, and ABT is one of the few that is reasonably priced.  If and when the market bounces next, I expect ABT to be a leader on the upside.  This point in the business cycle is when defensive names likely catch a bid.

I don’t expect a huge bounce, so I’m trading a call diagonal so that the position makes money if the stock just sits around $65 over the next month, but gives me cheap upside exposure in the interim:


TRADE: ABT ($64.77) Bought the Feb13 65 / Dec 67.5 call diagonal for $1.50

-Bought 1 Feb13 65 call for $2.23

-Sold 1 Dec 67.5 call at $0.71


TRADE RATIONALE: This is a similar structure to what I used in EBAY, but this time on the call side.  I chose the Feb13 at-the-money strike for my long because ABT reports earnings before Feb expiry, so implied volatility should not move much lower from here.  Meanwhile, given the strong selloff in ABT on big volume in the past week, I think the 67.5 level (around the 50 day moving average) will not be regained for some time.  With this structure, the short December 67.5 call will decay much quicker than the long Feb13 65 call, and so I can wait patiently for an eventual anticipated turn higher on the next market bounce.