As we have said on a few occasions in the last couple weeks, we are doing our best to fight urges, the technical and momentum set up is strong and equity markets for the most part have shrugged off what would normally be perceived as bad news. If you were to read the financial press, watch tv, or listen to your broker, most would be espousing the attractiveness to owning options with the VIX back below 14 for either protection against longs or for outright directional plays. We are not in the camp of buying puts against long stock (synthetically that is just a call) and we are generally not fans of straight overwriting , unless premiums are extremely elevated, which they are not for the most part. So that leaves us with looking at directional plays.
IN this environment, one of fairly excited optimism as it relates to the prospects for equity returns, we are in the camp that it probably makes good sense to leg into some bearish positions, with the idea that I will probably have to leg into the position. Doing this with outright long premium will be a tough way to make money without volatility, which leads us to the notion of using calendar spreads to set up for owning premium at a time for an event where we expect greater volatility.
As the market makes new highs, I want to look at stocks that are not participating. One that sticks out like a sore thumb is CAT. After being up at one point 10.5% on the year, the stock is now dead flat, and sitting right on important near term technical support. The one year chart below shows the fairly important technical break of the uptrend off of the Nov lows and very poor relative performance to the Dow Jones Industrial Avg of which it is a component.[caption id="attachment_23337" align="aligncenter" width="589"] CAT 1 yr chart from Bloomberg[/caption]
CAT’s financial performance is obviously very tied to that of the global economy as they get ~35% of sales from North America, ~25% from Europe and the Middle East, ~25% from Asia and ~15% from Latin America. Their ability to maintain revenue growth in emerging markets (33% in Asia & 32% in Latin America vs 25% in NA) is one of investors’ core concerns for the stock. With U.S. GDP likely to remain subdued below 2% for some time, Europe suffering from austerity in a recessionary environment and China settling into a sub double digit GDP environment (~7.5%), U.S. multinationals like CAT may struggle for the time being. On top of that, the recent rally in the U.S. dollar is going to hurt them as they translate overseas revenues back into USD.
CAT’s guidance and analysts expectation reflect that, with revenue and eps slated to decline 4% and 6% respectively in 2013, marked by a hefty jump to growth of 17% and 9% respectively in 2014. The valuation of the stock also reflects this trading at ~11x forward, which aside from the lows during the financial crisis is near a 15 year low.
MY VIEW: CAT is a tough press on the short side based purely on fundamentals, which for the moment appear to be clear as mud. Valuation is not a catalyst, but the technicals and poor relative performance suggest this stock could retest recent lows in the event of a broad market sell off or a stock specific event. I want to use options to take advantage of what I feel could be a process on the short side. Put Calendars, selling April to Buy May, which will capture the company’s April 22 Q1 earnings report, look attractive as I will look for a spread with little delta.
TRADE: CAT ($89.60) Bought the Apr / May 85 Put Spread for 1.00
-Sold 1 Apr 85 Put at 1.15
-Bought 1 May 85 Put for 2.15
Break-Even on April Expiration:
-My Max risk is the 1.00 in premium I paid for the spread, but as the spread only has 5 deltas to May so large price movements will not affect the value too much in the near term unless there is a dramatic move higher or lower which I don’t expect.
– My ideal situation would be for the stock to be at or slightly above 85. At that point I will look to spread the May 85 Puts in front of earnings.
Trade Rationale: While I want to look down, I am not yet ready to go all in and get outright short single names as I think a sustained correction will take some time to evolve and I want to sell shorter dated premium to finance the purchase of longer dated.