New Trade $CSCO – The Almost-Free Look

by Dan April 30, 2013 2:32 pm • Commentary

For those of us who are a bit skeptical of committing new capital to equities, particularly in the U.S., we find ourselves in a bit of a tight spot from a trading perspective in the current environment as major indices once again flirt with new all time highs.  While I fully recognize the potential for a blow off break-out, it is not in my DNA to “buy em” here.  To say I have had a cautious tone for some time would be an understatement, and the price action has proven me wrong, but we could be very close to an inflection point in the global economy, and thus the equity markets, and I want to look for defined risk strategies that afford me the opportunity to stay in the game without having to go “all in” by choosing a direction.

To be honest I want to short everything, throw a dart, and I’ll short it, but I am resisting those urges and actually have the fewest amount of trading positions that I have had all year.  But I am still very foccussed on finding “good options trades”, which leads me to some rotations going on in the market that don’t make a ton of sense to me, one of which would be the move into value tech (INTC, AMAT & MSFT) out of growth tech (QCOM & EBAY).  It feels that a few weeks ago portfolio managers have done screens for high dividend yield and low PE and just hit the BUY button in tech.  While this is not a trade that I am likely to chase, I am happy to identify other names that could benefit if this rotation continues but express the view in a way that offers more “optionality” than just being long.  

CSCO is a stock that has yet to report their current qtr (fiscal Q3 ends today), has a 3.2% dividend yield and trades at ~10x expected 2013 & 14 earnings.  Check.  With the market at all time highs I don’t think it makes sense to chase any longs, but with implied vol unusually cheap in the stock and a one day implied move on earnings of almost 5% 2 weeks before earnings, long premium structures in either direction with an earnings event could be just the way to get exposure to more than one potential outcome.

As for CSCO’s fundamentals, Here is what I wrote in my February preview to the prior earnings report, when the stock was around the same level it trades at today:

CSCO falls into the “stuck in the mud” cheap ol’ tech category.   What they lack in organic growth opportunities,  they make up for in balance sheet (40% market cap in cash, 26% net of debt), and cash re-payment to shareholders (pays a dividend that yields 2.66% & a massive multi-billion share repurchase).

CSCO has been in what feels like a perpetual restructuring for the better part of the last 10 years.  The company has used its tremendous cash flow generation to make hundreds of acquisitions both large and small in that period, none of which has ever really accelerated growth the way the bankers who pitched the deals had expected.  The company suffers the same conundrum that most of its large cap tech brethren face – the lack of organic growth and constant pricing pressure from competitors both large and small.

CSCO is obviously poised to benefit from any increases in IT spending from enterprise, carriers and governments, but this is likely to be in the low to high single digits for the foreseeable future.

The difference today is that investors are tripping over themselves to find safe yield somewhere in the world.  That’s to CSCO’s obvious benefit given its 3% yield, even if overall business trends are weak.  However, as IBM and ORCL have shown in their most recent earnings reports, there are some serious issues with macro demand in the enterprise segment of technology.

But the real reason we got interested in CSCO is because of the options pricing.  CSCO reports earnings on May 15th, after the market close, so the May 18th expiry options will capture the earnings move.  The May 18th 21 straddle is currently priced around $1.20, which implies a 5.75% move in CSCO if NOTHING happened between now and earnings.  Well, CSCO has moved 6.25% on average over the last 4 quarters, and 6.75% over the last 8 quarters.  So the current straddle price seems fair to slightly cheap, and we still have more than 2 weeks until earnings.

Part of the reason is that CSCO has been stuck between 20 and 22 for all of 2013:


[caption id="attachment_25370" align="alignnone" width="640"]1 year daily chart of CSCO, Courtesy of Bloomberg 1 year daily chart of CSCO, Courtesy of Bloomberg[/caption]


But regardless, the May options will hardly decay in the next 2 weeks given the size of those historical moves and an expected climb in IV.  With that in mind, buying a delta-neutral May straddle or strangle here is a very attractive trade that loses a small amount if the stock doesn’t move between now and earnings, but gives us a very cheap “look” on CSCO making a $1+ move in the next 2 weeks.

TRADE: Bought the CSCO ($21) May18th 21 Straddle for 1.20

-Bought 1 May18th 21 call for .60

-Bought 1 May18th 21 put for .60

Break-Even on May 18th Expiration:

-Profits below 19.80 and above 22.20, with no cap on profits above 2.20

-Losses of up to between 1.20 btwn 19.80 and 2.20, with max loss of 1.20 at 21

Trade Rationale:  With the broad market at what I perceive to be an inflection point, the rotation into value tech, the low implied volatility in CSCO in an expiration that captures an earnings event, I want to look to play for a move prior to earnings in either direction.  While I think there is a low likelihood that the stock will be exactly at $21 on May18th expiration, the chances of risking all of the premium for the straddle is very low.  I am placing this trade because I believe the chances of a 3-5% move prior to earnings are very high and this will give me the opportunity to scalp a profit.