Tuesday, September 10, 2013

CAT: Sideways play on heavy equipment

Caterpillar Inc. (CAT) has been tracing a symmetrical triangle since June 24. Its present boundaries are at $82.16 and $87.73, with the apex projected out to Jan. 30, 2014.

Beginning last week I've added sideways trades to my set of tools, allowing me to trade non-trending stocks using a combination of option vertical spreads called an iron condor. It's a combination of a bull put spread and a bear call spread that is fully profitable at expiration between the short put and call strike prices.
CAT 1 year daily bars

CAT fits into that category of trade. The strategy, as the tech folks say, is still in beta. It's looking good so far, but it's also still early days.

Caterpillar, of course, is a household name, at least if your household includes heavy equipment for moving dirt.

The Peoria, Illinois company is the world's leading manufacturer of such fun tools as tracked tractors, hydraulic excavators, backhoe loaders, motor graders, off-road trucks, wheel loaders and locomotives.

It also makes engines and defense products, and also has a financing and insurance operation.

Power systems, in fact, account for 36% of the stock price, and gear for resources industries -- mining, lumbering and the like -- account for another 36%.

Analysts are perfectly neutral about Caterpillar's prospects, giving it an enthusiasm index of zero, which is sort of what I want for a direction-neutral play.

The company reports excellent return on equity of 24%, but at the cost of a high level of debt, amounting to 145% of equity.

Looking at the last 12 quarters, Caterpillar has been profitable in each, although profit levels from the 4th quarter of 2012 have been significantly lower than the prior year.

The company has produced downside earnings surprises the past three quarters, and a fourth one back in 2011. The remaining eight quarters have surprised to the upside.

Institutions own 59% of shares, a fairly low level for a major company, and the price is below par. It takes only 92 cents in shares to control a dollar in sales.

CAT on average trades 5.4 million shares a day, sufficient to support a moderate selection of option strike prices with four-figure open interest. The front-month at-the-money bid/ask spread on calls is quite narrow at 2%.

Implied volatility stands at 21% and has been falling steadily since hitting a peak on Sept. 3.

Options are pricing in confidence that 68.2% of trades will fall between $81.14 and $91.86 over the next month, for a potential gain or loss of 6.2%, and between $83.93 and $89.07 over the next week.

Trading in options is quite active today, running at more than four times five-day average volume for calls and more than double average volume for puts.

The fair-price zone on today's 30-minute chart runs for $86.37 and $86.78, encompassing 68.2% of transactions surrounding the most-traded price, $86.49. I'm writing this in the first hour of the session, so the zone and the most-traded price are likely to change as the day progresses. CAT opened within the zone and dropped below the zone in the first half hour of trading, and is now trading at about the most-traded price.

Caterpillar next publishes earnings on Oct. 23. The stock goes ex-dividend in October for a quarterly payout yielding 2.77% annualized at current prices.

Decision for my account: I've opened a neutral position in CAT, structuring it as an iron condor sold for credit and expiring in October, short the $80 put and $90 call, and long the $77.5 put and $92.50 call.

The positions has 5.5% leverage to the downside and 1.9% to the upside. The hedge provides a zone of profitability 3% below the present triangle boundary and 3.1% above the present boundary. Maximum yield on risk is 38% at expiration.

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.

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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