Friday, December 13, 2013

KO: Bearish on Coke

Update 4/16/2014: I closed my options spreads on KO on Jan. 13, as they were about to expire, and have since been looking for an opportunity to roll forward into a fresh bear position.

That opportunity never came, and on Tuesday KO gapped to above the 20-day price channel on earnings that met expectations and were accompanied by news of strong growth in China. The story by Bloomblerg's Duane Stanford can be read here.

The exit signal was confirmed as KO traded still higher today, so I've calculated my results and am removing KO from the Roll Shelf.

KO shares rose by 0.7% over the 31-day lifespan of my position, or 7.9% annualized. The options, contrarily, had a positive 20% yield on risk, or +235.5% annualized.

The break above the price channel sent a bull signal, but it failed in my first round of analysis because of insufficiently good odds of success on bull signals.

Update 12/13/2013: KO maintained its downward momentum into the half hour before the closing bell, and I've opened a bear position, structuring it as a bear call options spread, sold for credit and expiring Jan. 18.

The position has 7.9:1 leverage with maximum yield on risk of 31.6% at expiration and a 2.6% hedge of profitability above the entry price.

Options modeling gives the short leg of the position a 67% chance of expiring out of the money for maximum profit.

The Coca-Cola Co. (KO) was the ultimate Warren Buffett bull play until it peaked in 1998. Buffett, trading the fundamentals, opened a position in KO early in his investing career and has stuck with it ever since. Today it amounts to nearly 17% of his portfolio.

However, the KO bull trend is well beyond its sell-by date. July 15, 1998 was the beginning, from $44.47, of a downtrend of major proportions in KO. It is, 15 years later, a downtrend that remains in force.

Within that downtrend, a retracement to the upside began on March 5, 2009 from $18.72. By my count, using Elliott wave analysis, that upward move ended on May 16, setting up a decline that eventually will move below $18.51, the post peak low set on March 10, 2003.

The May 16 peak at $43.43 ended wave C {+2} of the wave 2 {+3} retracement to the upside. It stopped only 2.3% below the 1998 high, an unusually robust correction.

Click on chart to enlarge
KO 5 years weekly bars (left), 180 days 2-hour bars (right)
KO has since traced out four waves a five wave decline of lower degree. It began the final decline, wave 5 on the chart, from $40.88 on Nov. 25.

The labels to the lower right of the right-hand chart places wave 5 in the larger context, within wave 1 {+1} of wave 1 {+2} of wave 3 {+3}, all to the downside.

The $36.83 near term target marks the start of wave 3. By doctrine, wave 5 must move below that starting point.

The minimum target, then, is 6.7% below today's opening price, with the possibility that it could drop much further. This is at a degree where each wave typically takes a month or two to complete its work.

This is the third bear signal since KO began wave 1 {+1} to the downside on May 16. The two completed waves produced a success and a failure. The success yielded 6.1% over 76 days, and the failure lost 1.8% over 13 days. The resulting 4.3% win/yield spread is quite sufficient to make a reasonable profit.

Everybody knows Coca-Cola. The Atlanta, Georgia soft drink company has been a global household name for most of the 125 years since it was incorporated. Today it markets more than 500 beverage brands.

Analysts are mildly optimistic about Coca-Cola's prospects, collectively coming down at an 8% enthusiasm index. Zacks is neutral, giving the stock a hold rank.

Certainly returns justify a glowing view. Return on equity is 29%, with long-term debt on the low side at 44% of equity.

Earnings tend to peak in the spring quarters, which have seen slight increases over a year earlier in the last two years. However, earnings remain well below their 2010 levels.

Coca-Cola has surprised to the downside three times in the past three years, most recently in the quarter reported on Oct. 15. It has surpised to the upside eight times.

The earnings yield is 4.89%, lower than 62% of other non-alcoholic beverage companies. The dividend, 2.83% annualized, showing that Coca-Cola retains 42% of earnings.

The stock is priced at 20 times earnings, and shares are also selling at a premium to sales. It takes $3.72 in shares to control a dollar in sales.

Institutions own 59% of shares.

KO on average trades 15.6 million shares a day and controls a large selection of option strike prices spaced $1.25 apart near the money. The front-month at-the-money bid/ask spread on puts is a narrow 2.9%.

Implied volatility stands at 18%, the highest point of the month, and began rising from 15% on Dec. 6. That position relative to the recent path means that options positions sold for credit, such as bear call spreads, will have the greater chance of success.

Options are pricing in confidence that 68.2% of trades will fall between $37.40 and $41.54 over the next month, for a potential gain or loss of 5.3%, and between $38.47 and $40.47 over the next week.

Contracts are trading actively today, with puts running 90% above their five-month average volume and calls at 45% above average.

Coca-Cola next publishes earnings on Feb. 10. The stock goes ex-dividend in February for a quarterly payout of 28 cents per share.

Decision for my account: The chart is solidly bearish with room to fall under the Elliott wave rules. The financials are fairly bullish, but the earnings pattern shows no surge to the upside and analysts are containing their enthusiasm nicely.

KO represents an old-line company where stability rules -- any large company that gives more than half its earnings to shareholders is plainly in a holding pattern. It's the sort of company where change mainly happens slowly, and when it speeds up, it's mainly due to exogenous factors.

If KO maintains its downside momentum into the last half hour before the closing bell, I intend to open a bear position, structuring it as a bear call spread, sold for credit and expiring Jan. 18. That sort of position makes money if the price stays even or if it falls, which seems appropriate for a stable operation like Coca-Cola.

If momentum falters, then I'll move KO to my Watchlist for later consideration.


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

I use the number 68.2% in using applied volatility to calculate the expected trading range. 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.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

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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