New Trade – Stray $CAT

by Enis September 9, 2014 1:47 pm • Commentary

Dan wrote a Name That Trade post on Thursday discussing the setup in CAT, emphasizing the vol dampening impact of the aggressive buyback program:

Unfortunately for CAT, this earnings recovery doesn’t have a whole heck of a lot to do with increased demand for their products as sales are expected to decline 1% this year, but likely have a ton to do with their fairly aggressive stock repurchases.  Earlier this year the company completed a $1.7 billion accelerated buyback and after the companies Q2 revenue miss, and subsequent decline announced anotheraccelerated share repurchase (ASR) this time to the tune of $2.5 billion.  This is financial engineering at its best.  In the short term shareholders should be nothing less than happy as the stock is now back within a few % of the 52 week highs, but still well below the all time highs made in early 2012:

CAT 5yr chart from Bloomberg

Just as most technicians had pointed at $80 (green line) for most of 2013 as significant support, most would suggest now that $117 (red line), the prior double top high should serve as important long term resistance with $100 serving as intermediate term resistance (yellow line).

Partly due to the buybacks, options pricing is very cheap, as Dan pointed out:

30 day implied volatility in CAT, courtesy of Bloomberg
30 day implied volatility in CAT, courtesy of Bloomberg

At the same time that options traders are not expecting much movement in CAT, the commodity-related markets have started to experience much more volatility in the past couple of weeks.  Dan discussed the pickup in macro volatility in today’s MorningWord post.

Finally, the fundamental backdrop for Caterpillar is hardly encouraging.  Chinese demand remains tepid, and the property market is showing more signs of being at risk for a major drop.  The FT discussed those signs in a recent article, including the following charts to illustrate: 

Screen Shot 2014-09-09 at 12.14.27 PM

Screen Shot 2014-09-09 at 12.15.52 PM

Caterpillar’s exposure to emerging markets is significant, particularly the mining industry, which has been driven by industrial demand in China.  A slowdown there is going to be a major headwind for the company’s restructuring plan.

Given the low implied volatility, poor fundamental backdrop, and the inability of CAT to rally above the $110 resistance level on the recent market strength, we want to play for a move back to the $100 support level in the coming months.  [private]

TRADE – CAT ($108) Bought the Nov 105//100 put spread for 1.35

-Bought 1 Nov 105 Put for 2.50

-Sold 1 Nov 100 Put at 1.15

Break-Even on Nov Expiration:

Profits: btwn 100 and 103.65 make up to 3.65, max gain of 3.65 at 100 or lower

Losses: btwn 103.65 and 105 lose up to 1.35 , with max loss of  1.35 at 105 or higher

Rationale:  We view the likelihood of a 5-10% move lower in CAT as higher than a 5-10% move higher in CAT, and the low level of implied volatility along with the late October earnings catalyst in CAT means that the put spread is not going to decay much in the near term.  We would likely take the trade off on a move to $100 support (also the 200 day moving avg- green line below), or a clean break of $110 resistance (red line below).

[caption id="attachment_45228" align="aligncenter" width="600"]CAT ytd chart from Bloomberg CAT ytd chart from Bloomberg[/caption]