The $CAT in the Splat?

by Dan April 7, 2016 1:12 pm • Commentary• Trade Updates

Shares of Caterpillar (CAT) are up 33% from its 52 week and 6 year lows made in late January, with the stock now up 10% in 2016. The year to date out-performance comes after a very volatile few years with the stock down 33% from its all time highs made in early 2012 but has recently broken from a very steep downtrend from mid 2014 when the company stopped the silliness of accelerated buybacks:

CAT 5 year chart from Bloomberg
CAT 5 year chart from Bloomberg

When I look at the chart above and marry it with the fact that the company is expected to post its 4th consecutive earnings and sales declines in 2016, with the stock trading at 20x those expected earnings (that may be down 60% from their 2012 peak, with sales expected to be down 38% from their 2012 peak) It makes me think that the $80 prior support level (that broke hard last year) will become massive technical resistance. Given the state of the global economy, and where CAT’s growth will materialize from, I suspect this will be a late 2016 occurrence at best.

The next identifiable catalyst will be Q1 earnings expected April 22nd before the market open. The options market is implying about a 6.5% move between now and Friday April 22nd’s close, which seems about fair to possibly a tad expensive considering its a little more than 2 weeks away, and the fact that the stock has moved on average about 2.5% over the last 4 qtrs following earnings, and its 10 year avg one day post earnings move has been about 4%.

Short dated options prices have picked up a bit of late, with 30 day at the money implied volatility (blue line below) at 32.5%, up from 2016 low of 25% mid last month, despite 30 day at the money realized volatility (how much the stock has moved, white line below) at the lows for 2016:

From Bloomberg
From Bloomberg

So what’s the trade??  

Target earnings, but look to finance in the next week using a put diagonal strategy, then look to turn into a vertical put spread:

*CAT ($74.55) Buy April 22nd 74 / April 15th 72 put diagonal for $2.10

-Buy to Open 1 April 22nd (weekly expiration) 74 puts for 2.50

-Sell to Open 1 April 15th (regular expiration) 72 puts at 40 cents

Break-Even on April 15th expiration (next Friday):

Best Case Scenario: stock is at or near $72, the April 15th 72 put expires worthless (or is covered for pennies) the April 22nd 74 put that we are long gains in value as the option picks up deltas, and then we will look to turn the long put into a vertical for earnings, further reducing the premium at risk by selling a lower strike put.

Worst Case Scenario: the stock moves meaningfully higher between now and April 22nd and both options lose value. If this were the case then we would likely revert to our 50% premium stop on long premium directional trades.

Max risk is the initial $2.10 premium outlay, or 2.8% of the stock price, which by next Friday’s close we hope to reduce further.

Rationale: all things being equal, the April 22nd 74 put we are long should stay bid in vol terms, off-setting time decay between now and earnings that occur on the morning of weekly expiration.  The idea by first doing a calendar diagonal is too off set decay in the event the stock moves a tad higher with the intent of rolling the short strike next Friday to further reduce the cost of the earnings trade.

Lastly, why get so creative? Well I’ll offer our usual disclaimer for long premium directional trades into events… need to get a lot of things right to merely break-even, direction, timing and magnitude of the move, this strategy attempts to ease some of the headwinds.