Monday, May 12, 2014

AET: A long-term trade

Update 2/17/2015: I've closed my position before the long-term capital gains period kicked in in order free up cash for another opportunity.

Share prices rose by 21.2% over the 272-day lifespan of the postion, or a 37% annual rate. The stock position and a hedge in combination produced a 20.6% yield on debit, for a 27% annual rate.

Update 8/21/2014: I've closed the bear hedge after the price closed above its stop/loss point, and also above the 10-day price channel, confirming the signal. As is my practice, I won't calculate profit and loss until the entire position series has ended, which will be no earlier than May 2015 in the case of AET.

Update 7/31/2014: I've opened a bear hedge against my longer-term bull position in AET. The price closed below the 20-day price channel on July 30, the second trading day after earnings beat analysts estimate, and confirmed the signal by trading lower the next day.

I've structured the hedge as a bear put spread, long the $80 puts and short the $75 puts, bought with a debit and expiring in January. Leverage is about 5:1.

The decline follows the peak of wave 3 {+12} on July 22 at $85.72, completing the rise from Oct. 29, 2013 from $60.32. The wave lasted for 262 days. There are no guarantees, but if the downward correction at the {+1} degree is proportional, then it would carry into April 2015.

Click on chart to enlarge.
AET 3 years 2-day bars
Aetna Inc. (AET) sent a bull signal on Friday and confirmed it today by trading still higher above its 20-day price channel. However, it failed to make it past the first round of analysis because its bull signals since June have been profitable only 20% of the time.

However, it is a perfect candidate for a trade under my longer-term rules, which require me to hold the position for at least a year to take advantage of the lower tax rate on long-term capital gains.

The one absolute requirement for a symbol under these rules is that it have options that are sufficiently liquid for use as a bearish hedge in case of a downturn. If the symbol lacks liquid options, it must have an avatar -- a counterpart -- that is sufficiently similar in its profile that it can be used as a hedge.

Aetna meets the options test and so is suitable for a long-term trade.

The company as a health insurer is operating in a marketplace facing the challenges of great regulatory change that is forcing companies into new ways of doing things. It is from such change that opportunities arise. Aetna isn't the biggest kid on the health insurance block, and perhaps that is a good thing, if it can function as a scrappy underdog to carve out a place in the new world created by Obamacare.

The Company

For shorter-term plays I look at the chart first, but for the longer term, the company and its fundamentals are more important.

Aetna, headquartered in Hartford, Connecticut, is a Fortune 100 company that is a major provider of health insurance. A survey last year ranked Aetna as #5 in market share among U.S.  health insurance companies.

The primary question for this sector is how President Obama's health-care reforms will affect the business.

My judgment is that the Affordable Care Act is oriented so strongly in favor of the private sector that its main impact will be to grow the insurers' customer base while allowing adequate reimbursement from premiums, something that can help the bottom line if companies are smart enough to provide service at competitive prices by operating more efficiently.

In the newly open marketplace for health insurance, price and service are the keys to the game.

Moreover, Aetna is a major provider of policies that supplement the government-run Medicare and Medicaid programs for the elderly and the poor, respectively. The elderly are a fast growing segment of the American population, as the post-World War II population surge known as the Baby Boom reaches retirement age.

The company, however, is in a crowded marketplace and isn't the dominant player nationally. This limits its ability to control its competitive environment.

Analysts are positive in their assessment of Aetna's future, collectively coming down with a 29% enthusiasm rating.

The company reports return on equity of 17%, with debt running at 53% of equity. Those figures fail to meet my criteria for a growth stock. The return on equity declined in 2012 and 2013 from the year before, which is less than idea.

Earnings have been in an uptrend for at least the past five year with a counter-trend correction the first half of 2013. Earnings for the 1st quarter of 2014 were the highest of any quarter for at least the past three years. During that period Aetna has surprised to the upside seven times, including the most recent quarter, and to the downside five times.

Aetna's earnings yield is 7.49%, higher than 66% of other accident and health insurers. That compares to a 2.65% yield on the 10-year U.S. Treasury note. The company's dividend is 1.19% annualized at today's prices and amounts to about 16% of the earnings yield.

The company's growth implies a price of $67.15, compared to $75.88 as of this writing. So the market is pricing in a 13% premium for future growth.

The growth-implied earnings yield is 8.46%, meaning that buying at the current price means foregoing nearly 1% in yield.

The stock is selling at 13 times earnings but at a discount to sales. It takes 51 cents in shares to control a dollar in sales.

Institutions own 90% of shares.

Aetna next publishes earnings on July 29. Shares go ex-dividend in July for a quarterly payout of 22.5 cents per share.

The Chart

Using Elliott wave analysis, I've concluded that AET is in the final portion of its rise that began Feb. 18, 2000 from $4.81. The peak prior to the Great Recession was $60 on Dec. 11, 2007. From that point, the end of wave 3 {+3}, AET plummeted to its recession low of $14.21 on Nov. 21, 2008.

Wave 5 {+3} has so far risen 440% from that point. The value of the growth-implied price analysis in the prior section is that it shows Aetna to still be reasonably priced even after such a large rise.

Click on chart to enlarge.
AET 20 years monthly bars (left), 4 years 8 months 3-day bars (right)
The count within wave 5 {+3} is a ambiguous. I see it as being in the middle wave, 3 {+1} of the rise from July 25, 2012 beginning at $34.58. Wave 3 {+1} began Oct. 29, 2013 from $60.32 and so is only about seven months old.

The first wave up at this degree, wave 1 {+1} endured for 14 months, and third waves usually take a longer time to reach completion. For example, at the {+2} degree, wave the first wave lasted a year and the third wave for 3 years 4 months, more  than triple the time.

If wave 3 {+1} shows similar behavior, then it could last into the summer of 2017. There are no guarantees about time in Elliott, of course, but also on this chart there is no limit to the length of wave 3 {+1}.

Liquidity and Volatility

AET on average trades 2.8 million shares a day and supports a wide selection of option strike prices spaced $5 apart, with open interest running to three figures near the money.

Options under my long-term rules are used to hedge downturns. The front-month at-the-money bid/ask spread on puts is 11.5%, compared to 0.3% on the most-traded symbol on the U.S. exchanges, the exchange-traded fund SPY.

Implied volatility stands at 21%, 16% below backward-looking historical volatility. That compares to 12% implied volatility on the S&P 500 index.

AET's volatility has been generally trending lower in a series of very wide swings over the past year. It just hit its lowest point of the year, in the 1st percentile of the one-year range.

Options are pricing in confidence that 68.2% of trades over the nexst year will fall between $59.75 and $91.59 for a potential gain or loss of 21%.

The implied volatility range falls within wave 5 {+2} to the upside on the chart.

Decision for My Account

I've opened a bull position in AET under my longer-term rules, structuring the position as long shares. I intend to hold them for at least a year and hedge downturns with bearish option spreads.


My shorter-term trading rules can be read here. My longer-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 shorter-term 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 decisions for his or her own account, and take responsibility for the consequences.

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