Thursday, September 20, 2012

SDRL: Second-guessing the breakout

Seadrill Ltd. (SDRL) gapped below its 20-day low Thursday morning, triggering a Turtle Trading bear signal, but then rose for a net gain (so far) for the day.

This is the sort of move that makes traders second-guess their rules. 

For the Turtle Trading rules (read them here) say that when a breakout occurs, the trade must be taken as long as the account has uncommitted funds.

Yet, buy into rising stock? One that has gone up nearly 1% intra-day? Madness, I say!

Charts like Seadrill's explains why it is not uncommon to see traders sitting glassy eyed before their screens, muttering softly in a state of mild paralysis.

The psychology of trading is a source of endless fascination. In the end, it all comes down to a simple dictum: "Act!" To trade is to act, and the trader who fails to act is a trader in name only.

(Rejecting a trade, by the way, counts as acting. I'm not at all arguing for indiscriminate commitment of funds.)

SDRL's 20-day low is at $39.45. The gap carried it to an open that was 0.9% below the prior day's close. Today's high so far (three hours before the close) has touched the 20-day low, but has not broken back above it.

The stock has been a sideways trend since early August, with a ceiling a bit below $42 and a floor of around $39.50. Today's decline is the second test of that lower level. The previous test on Sept. 5 set the $39.45 low that is now the breakout level.

It would take a break below $37.45 before I could call SDRL as being in a downtrend using traditional analysis, and that's a highly questionable conclusion. It is just a muddy chart at the near-term range.

Longer term, the stock peaked at $42.34 late last winter, fell to $31.37 in early June, and then again rested the $42 level without setting a higher high. From that view, it would take a decline below $31.37 to produce a lower low that could be called a downtrend.

Seadrill, a off-shore drilling contractor headquartered in Hamilton, Bermuda with operations run out of Stavanger, Norway, is followed by analysts who are, for the most part, firmly in the bear camp. The enthusiasm index is a negative 64%, down from 60% a month ago.

In part, that may be because annual earnings have been flat that past three years, and are looking that way this year as well.

The company is a money maker -- always profitable -- and has a fine return on equity of 22%. That has come at a price, however, of a high level of long-term debt amounting to 125% of equity. 

The debt really shouldn't come as a big surprise. Drilling is a capital intensive job -- it takes lots of big, expensive equipment to make it happen. The company is operating about 40 rigs in offshore fields throughout the globe.

Institutions own only 33% of shares, and the price has been bid up to an extraordinary level. It takes $4.36 in shares to control a dollar in sales.

SDRL on average trades 2 million shares a day. It has a wide selection of option strike prices with open interest near the money running in the three- and four-figure range. The bid/ask spread for front-month at-the-money calls is 11%.

Implied volatility, 51%, is near the top of the six-month range. It began declining a week ago but rose today.

Options are pricing in confidence that 68.2% of trades will fall  between $33.61 and $45.11 over the next month, for a potential maximum gain or loss of 15%.

Options are trading at only 5% above their five-day average volume, with calls leading at 49% above average, compared to puts at only 32%  below average.

The fair-trade zone runs from $39.21 to $39.36, encompassing 68.2% of transactions surrounding the most-traded price, $39.30. The stock is trading at the high end of the zone as of this writing.

Seadrill next publishes earnings on Nov. 30. It goes ex-dividend in December for a quarterly payout yielding 8.54% annualized.

Decision for my account: I won't take the trade because my trading funds are fully committed under my rules. If I were playing it as a Turtle Trade, I would structure it as long the January $40.85 puts for 7x leverage. (The strike price is no type -- it's a foreign company and sometimes their options get weird.)

SDRL is also interesting as a diagonal spread -- big implied volatility means big yield on the short leg. And as a trader, given the ambiguities of the chart, I would be tempted to structure the position as a vertical spread, to hedge against the price rising.

But both of those produce potential problems because of the high dividend yield, which increases the odds dramatically of involuntary assignment of short call options held past the ex-div date. 

Disclaimer
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.

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