CP: A railroad bull play

Update 6/7/2013: CP gave an exit signal on June 4 and I closed the position on June 7. Shares gained 1% from initial entry to exit. I added to the position several times, and the loss on my overall basis was 0.9%. I structured the position as vertical credit option spreads, which sustained a 1.7% loss on risk.

Canadian Pacific Railway Ltd. (CP) broke above its 20-day price channel on Thursday and confirmed the bull signal the next day by trading above the $125.22 breakout level.

The signal comes amid a correction within an uptrend that began in October 2011 from $44.98 and carried the price up to a high of $130.81 on March 28. From that point the uptrend faltered in a four-day slide that carried the price down to $115.60, followed by a sideways trend.

Today's continuation of the breakout is the first move above that sideways trend, suggesting renewed buying interest that will test the pre-correction high, which lies 4.5% above the breakout level.

This is CP's ninth breakout to the upside since the present uptrend began. The eight completed trades split evenly between successes and failures, with winners yielding 13% on average and failures losing 5.2% on average.

Despite the even odds, the win score -- the yield on successful trades adjusted by the 50% success rate -- is 6.5%, well above my 5% minimum preference. And the win/lose yield spread is 7.8%, which is quite good.

Over the longer term, the period from January 2009, around the time that the broad markets began recovering from the post-recession crash, CP has performed poorly, with only a 40.9% success rate and a 3.6% winning score. The win/lose yield spread is 4.6%.

That's all to say that CP is doing much better now that it was.

Canadian Pacific, headquartered in Calgary, Alberta, operates trains on 14,7000 miles of track in primarily in Canada, but also in the U.S. Midwest and Northeast regions.

Despite CP's stellar chart, analysts really dislike the company's prospects, collectively giving it a negative 57% enthusiasm rating. "Hate" might be too strong a word to describe their sentiments, but they certainly are curbing their enthusiasm.

Canadian Pacific reports return on equity of 16% with a fairly high level of debt amounting to 84% of equity.

Looking at the last 12 quarters: CP has been profitable throughout the period but without a trend to the profit change. Nine quarters have shown upside earnings surprises, and three have surprised to the downside.

Institutions own 75% of shares, and the price has been bid up so that it takes $3.81 in shares to control a dollar in sales.

CP on average trades 899,000 shares a day and has a moderately wide selection of option strike prices with open interest running to three figures and a front-month at-the-money bid/ask spread on calls of 9.8%, which is a bit high.

Implied volatility is running at 25% and has been moving sideways with a slight downward bias since late April.

Options are pricing in confidence that 68.2% of trades will fall between $117.65 and $136.13 over the next month, for a potential gain or loss of 7.3%, and between $122.45 and $131.33 over the next week.

Options are mainly trading toward the bull side, with calls running at 3% above their five-day average volume, compared to 40% of average for puts.

The fair-price zone on today's 30-minute chart runs from $126.62 to $128.32, encompassing 68.2% of trades surrounding the most-traded price, $127.28. The price moved above the zone in the first hour of trading but retreated to below the zone in the subsequent hour. With 2-1/2 hours before the closing bell, CP is trading within the zone but below the most-traded price.

Canadian Pacific next publishes earnings on July 26.

Decision for my account: I like the chart, a lot. The odds are a bit lacking, but the score and win/lose yield spread helps make up for it. The 4.5% space between the breakout level and the previous swing high provides some easy money room for the price to fluctuate in before it hits major resistance. 

I've opened a bull position on CP, structuring it as a vertical credit spread of options expiring in June, short the $125 put and long the $120 put. Ths provides a potential maximum yield of 23% and a 2.9% downside cushion between the entry price and the breakeven point at expiration.

References

My trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

At several points in my analysis I use the number 68.2%. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

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.